2007-05-2007 Where Did The Risk Go? How Misapplied Bond Ratings Cause Mortgage Backed Securities and Collateralized Debt Obligation Market Disruptions PDF

mason_rosner_v8 May 14, 2007
Where Did the Risk Go? How Misapplied

Bond Ratings Cause Mortgage Backed
Securities and Collateralized Debt Obligation
Market Disruptions
JOSEPH R. MASON
JOSHUA ROSNER
Many of the current difficulties in residential mortgage-backed securities (RMBS) and

collateralized debt obligations (CDOs) can be attributed to a misapplication of agency ratings.
Changes in mortgage origination and servicing make it difficult to evaluate the risk of RMBS
and CDOs. We show that the big three ratings agencies are often confronted with an array of
conflicting incentives, which can affect choices in subjective measurements of risk. Of even
greater concern, however, is the fact that the process of creating RMBS and CDOs requires the
ratings agencies to arguably become part of the underwriting team, leading to legal risks and
even more conflicts. We analyze the fundamental differences between rating structured finance
products like RMBS and CDOs and traditional products like corporate debt. We show that the
inefficiencies of rating RMBS and CDOs are leading investors to discount U.S. markets. We
conclude by providing several policy implications of our findings.
INTRODUCTION ................................................................................................................... 3
I. UNRECOGNIZED RISK AND BOND RATINGS ................................................................. 3
II. STRUCTURAL CHANGES IN THE BOND RATING INDUSTRY: THE MOVE FROM PASSIVE
TO ACTIVE ................................................................................................................... 7
A. A Brief Background on the Role of Credit Rating Agencies ................................ 7
B. Are Credit Rating Agencies Still Publishers or Are They Underwriters?.......... 11
C. New ConflictsThe Buy Side ............................................................................ 17
D. The Problems With Ratings In Structured FinanceEvolving Models ............. 19
E. Regulatory Issues............................................................................................... 28
F. Rating Agencies Are Activist in Ways They Have Never Been........................... 31
G. Other Legal Risk Securitization Law ................................................................. 33
III. TRADITIONAL BOND RATINGS DO NOT PROPERLY ACCOUNT FOR RESIDENTIAL
MORTGAGE-BACKED SECURITY RISKS ...................................................................... 34
A. Pooling Mortgages does not create Diversification .......................................... 35
B. Current Bond Ratings Methods are Misleading when Applied to RMBS .......... 36
1. Corporate Default Risk is a Function of Investment Decisions, while
RMBS Default Risk is a Function of Investment Performance ................... 37
2. Performance Point Estimates that are the Basis for Corporate Bond
Ratings are not Relevant for RMBS ............................................................ 38
3. Cumulative Losses Can Only Increase in Structured Finance Debt.......... 40
4. The Statistical Distribution of Mortgage Pool Performance Is Skewed
Relative to that of Corporate Investments................................................... 41
5. Mortgage Pool Cumulative Loss Distributions Narrow over Time ............ 43
6. Implications: When Mortgage Pools Do Not Perform, the RMBS Will
Not Be Promptly Downgraded by Traditional Ratings Methods ................ 44
Associate Professor of Finance and LeBow Research Fellow, Drexel University

LeBow College of Business, Senior Fellow at the Wharton School, and Visiting Scholar,
Federal Deposit Insurance Corporation.
Managing Director, Graham Fisher & Co.
DISCLAIMER: NOTHING IN THIS REPORT SHALL BE CONSTRUED TO BE LEGAL OR INVESTMENT
ADVICE. IT IS NOT INTENDED TO BE CONSIDERED OTHER THAN THE OPINIONS OF ITS AUTHORS
AND DOES NOT PROPOSE SPECIFIC ADVICE ON ANY SECURITIES OF ANY PARTICULAR ISSUER OR
COMPANY. THE INFORMATION AND RECOMMENDATIONS CONTAINED HEREIN ARE BELIEVED TO
BE ACCURATE - HOWEVER NO GUARANTEE OR WARRANTY EXPRESSED OR IMPLIED IS GIVEN.
2 Joshua Rosner & Joseph R. Mason
7.Implications: When Mortgage Pools Perform Normally, Credit

Enhancement Is Wasted .............................................................................. 45
8. Summary ..................................................................................................... 47
C. Case Examples of Structured Finance Performance ........................................ 48
IV. THE COMPLEXITY OF RESIDENTIAL MORTGAGE-BACKED SECURITIES MASKS
INADEQUATE RISK TRANSFER ................................................................................... 52
A. Mortgage Pools Are Difficult to Value .............................................................. 53
B. Complex Arrays of RMBS are Difficult to Value ............................................... 56
C. The Complexity of Valuing the Pool and the Array of RMBS Backed by the
Pool Makes it Nearly Impossible to Trace the Accuracy of the Risk Transfer
in the RMBS Market........................................................................................... 59
V. BOND RATINGS ALSO DO NOT ACCOUNT FOR COLLATERALIZED DEBT OBLIGATION
RISKS ......................................................................................................................... 60
VI. THE COMPLEXITY OF COLLATERALIZED DEBT OBLIGATIONS FURTHER MASKS
INADEQUATE RISK TRANSFER ................................................................................... 62
A. The Complexity of Valuing the Pool of RMBS and other Investments and the
Array of CDO Backed by the Pool Makes it Nearly Impossible to Trace the
Accuracy of the Risk Transfer in the CDO Market ............................................ 62
B. Ratings Arbitrage: CDO Ratings Methods Are Looser than RMBS Ratings
Methods, Even when CDOs are Solely made up of RMBS................................. 66
VII. MORTGAGE-BACKED SECURITIES AND COLLATERALIZED DEBT OBLIGATIONS
PROVIDE SUBSTANTIAL LEVERAGE TO THE U.S. MORTGAGE INDUSTRY AND
ECONOMIC PERFORMANCE ........................................................................................ 68
A. The Incredible Growth of the CDO Sector ........................................................ 68
B. By Investing Heavily in Junior RMBS and ABS Tranches, CDOs Provide a
Substantial Part of the Base for the Roughly 10:1 Leverage in Todays
RMBS Market..................................................................................................... 69
C. CDO Ratings Changes Follow (Scarce) Ratings Downgrades for
Constituent RMBS Collateral ............................................................................ 72
D. The CDO Sector will Drop Collateral Sectors that Underperform .................. 76
E. Domestic Links between Mortgage Markets, RMBS, and CDO Funding and
the Housing Sector and Economic Growth........................................................ 77
F. Both Domestic and International Markets are Already Discounting RMBS,
and CDOs ......................................................................................................... 80
VIII. POLICY IMPLICATIONS ........................................................................................ 84
BIBLIOGRAPHY ................................................................................................................. 86
May 2007 Mortgage-Backed Security Ratings 3
INTRODUCTION
The residential mortgage-backed securities (RMBS) market has experienced

significant changes over the past decade. Non-agency (private label) securities,
which are not guaranteed by the government or the government-sponsored
enterprises, now account for the majority of RMBS issued. When changes to
origination and servicing occur unpredictably over time or across issuers, thereby
affecting the cash flows of some unknown number of mortgages, RMBS become
more difficult to value. Hence, changes in origination and servicing practices,
along with the existing complexity of RMBS, results in greater opacity in the
RMBS market.
Those sentiments suggest that the RMBS market was transparent at some
previous instant. In this paper, we explain that the general nature of bond ratings,
as well as a fundamental misapplication of the corporate ratings process to
RMBS, has never provided sufficient transparency for market efficiency. Rather,
the benefits of securitization to date have rested primarily upon a chance
combination of a lengthy economic expansion coupled with asset price increases
of the sort that are fundamentally excluded from standard measures of inflation.
We discuss ways in which conflicting incentives and the misapplication of
corporate bond ratings methods have skewed the evaluation of risk in RMBS and
CDOs.
The paper begins with a background discussion of beliefs about fundamental
changes in risk in todays markets. In Part II, we review many well-known legal
and institutional shortcomings of the way the bond ratings industry presently
approaches RMBS. Part III presents fundamental flaws to the ratings process for
RMBS and CDOs, suggesting that a substantial overhaul is necessary to
adequately characterize risk in not only RMBS, but the entire universe of
structured finance. In Part IV, we explain how the complexity of RMBS and
ABS masks risk transfer, which can fool investors and regulators into believing
that securitized funding arrangements are safer than they really are. Parts V and
VI show that similar problems affect the CDO markets, where risk is also ill-
characterized and masked through complexity. Part VII links those risks to
present economic conditions, suggesting that growth will be restored to
equilibrium whether policymakers act or not. In Part VIII, we suggest policy
conclusions based on our findings. Overall, fundamental differences between
RMBS and corporate investments necessitate more dynamic ratings and greater
transparency if ratings are to be the basis of regulatory approaches RMBS and
other structured finance products under arrangements like ERISA and Basel II.
I. UNRECOGNIZED RISK AND BOND RATINGS
Conventional wisdom holds that market volatility or market risk has declined.
For risk that remains, markets have reduced the price for taking on that risk.
Figure 1 illustrates the conventional view as it related to mortgage markets. Since
2003, swaption volatility has decreased substantially, along with the Mortgage
Bankers Association Refinancing cost index and residential mortgage-backed
security (RMBS) yield spreads over LIBOR. Such circumstances have reduced
mortgage costs to homebuyers and set the stage for the new financial markets,
that are thought to more efficiently value and price risk. Of course, risk does not
go away. It can be diversified in portfolios, but diversification works to only

offset risk. Hence, if risk is priced lower, that pricing must reflect either an
increased appetite for fully-disclosed risk or the lack of disclosure of risk for the
same risk appetite.
FIGURE 1: RESIDENTIAL RMBS YIELD SPREADS, MBA REFI INDEX, AND

2X10 SWAPTION VOLATILITY
Source: Nomura, Structured Finance Trends Yield Spreads, Credit Support, and Collateral
Performance The Big Picture, June 27, 1005, at 9.
Our previous report illustrated many of the key changes to residential

mortgage origination and servicing standards that have occurred over the past
two decades. Those changes have ultimately resulted in a wider range of risk
among the types of financial instruments we call mortgages. Figure 2 illustrates
FIGURE 2: RISK GRADING IN THE MORTGAGE INDUSTRY
Source: Fitch IBCA, Rating U.S. Residential Subprime Mortgage Securities, Jul. 18, 2001.
the increased gradation of risk among mortgage borrowers. The additional grades
of risk arise from the willingness to underwrite mortgages for more risky
borrowers, encouraged by the democratization of credit since the 1970s, as well
as making riskier loans to more typical borrowers. Both practices increase the
total amount of risk to be sold in the marketplace. However, increased grading of
risk induced increased complexity, and therefore increased opacity. Risk that is
more difficult to see, by virtue of complexity, is risk just the same.
There are plenty of reasons to believe that the amount of risk in the
marketplace has increased while opacity has made it seem otherwise. Figure 3
shows that defaults on ABS and RMBS increased substantially between 1991 and
2003 and declined sharply thereafter. During that decline, however, the ratings
FIGURE 3: DEFAULTS ON ABS AND RMBS, 1994-2005
Source: FitchIBCA, Fitch Global Structured Finance 1991-2005 Default Study, Nov. 26, 2006.
agencies have continued to revise their loss expectations to account for the
dynamics of the mortgage meltdown. For instance, on March 27, Standard &
Poors raised its expectation for losses on 2006 subprime mortgage bond issues
to as high as 7.75 percent from a previous peak assumption of about 6.5 percent.1
Moodys made similar revisions on April 20, 2007. As a result, both Moodys
and Standard & Poors parent corporation stock prices are down over the past
three months, partially due to reputational concerns.2
Of course, it is up to the reader to translate the revised loss expectations into
default scenarios. Figure 4 provides that translation from Fitchs Residential
Mortgage-Backed Securities Criteria. Ratings agency criteria are the
documentation circulated by ratings agencies to describe their loss analysis and
ratings methods. Figure 4 shows that Fitch anchors their expectations of the
relationship between losses and ratings changes in a number of academic studies
as well as their own research. The data are taken from criteria published well
before the meltdown, offering insights untainted by recent adjustments to
ratings agency methods meant to better capture risk (next time). Figure 4
illustrates that loss levels of 7.7 percent are expected to begin to impose losses on
investment-grade securities.
1. S&P raises 2006 subprime mortgage loss expectation, REUTERS, Mar. 27, 2007.
2. Serena Ng, Subprime Cloud Overshadows S&P, Moodys, WALL ST. J., Apr. 24,
2007, at C1.
FIGURE 4: COLLATERAL LOSSES AND BOND DEFAULTS
Source: FitchIBCA, Residential Mortgage-backed Securities Criteria, Dec. 16, 1998.
Data from the Mortgage Bankers Association suggests that losses may
continue to mount. The MBA Survey shows that many states are already
illustrating foreclosure and near foreclosure rates levels not seen since the thrift
crisis. Mortgage Bankers Association data from the third quarter of 2006 showed
that Ohio had the highest foreclosure rate in the country, while other Midwestern
states with fairly low home price appreciation over the last decadenamely,
Michigan, Indiana, Iowa, and Kentuckywere also among the highest. At that
time, California was below the U.S. average. States like Arizona and Nevada
ranked among the lowest, but foreclosures in those states are accelerating.
What is interesting about these trends is that while as early as January 2005,
delinquency and foreclosure data pointed to substantial deterioration in the
overall credit performance of even fixed-rate prime mortgage loans, actual losses
on securitized pools were extremely low during that period. Hence, S&P reported
981 RMBS upgrades and only RMBS 17 downgrades in 2004, and Moodys
reported 414 RMBS upgrades to only 4 RMBS downgrades for the same period.
That is the kind of news that led many to believe in decreased market risk. Figure
5 suggests the trend toward increased home price appreciation could be at its end,
leaving losses to accumulate in pools for some time.
FIGURE 5: U.S. HOME-PRICE APPRECIATION
Source: Nomura, Securitization & Real Estate Update, Mar. 1, 2007.

It bears emphasis that the strong home-price appreciation since 1998 is the
principal factor that prevented delinquencies and defaults from developing into
losses before 2007.3 Figure 6 shows that markets are therefore beginning to price
risk in the housing sector with strong increases in spreads on almost all types of
securities.
FIGURE 6: ABX:HE TRANCHE SPREADS FOR PRICING RMBS
Source: Nomura, Securitization & Real Estate Update, Feb. 28, 2007.
The following sections discuss elements of risk that were missed by investors
and ratings agencies and what can be done to better evaluate risk going forward
from the present meltdown. We explain that movements toward transparency for
these fundamental factors can go a long way to ensuring stability for the socially
and economically important segment of the U.S. economy, one that is crucial to
both consumer well-being and economic growth.
II. STRUCTURAL CHANGES IN THE BOND RATING INDUSTRY: THE MOVE FROM
PASSIVE TO ACTIVE
A. A Brief Background on the Role of Credit Rating Agencies
Since the creation of the modern credit rating industry by John Moody in
1909, ratings were offered to investors to assess credit-risks to the ability of a
dynamic institution to meet its financial obligations. Historically, the rating
agencies revenues were generated by subscription fees from subscribers who
received research and ratings on the creditworthiness of issuers of debt
securities.4
The value of ratings to investors is generally assumed to be a benchmark of
comparability it offers investors in differentiating between securities. Credit
rating agencies (CRAs) have long argued that the ratings scales they employed
were consistent across assets and markets. Not long ago Moodys stated The
need for a unified rating system is also reflected in the growing importance of
3. Nomura, Structured Finance Trends Yield Spreads, Credit Support, and

Collateral Performance The Big Picture, June 27, 2005, at 9.
4. Ruth Rudden, Evolution of Credit RatingsPart 1, CariCRIS, available at
http://www.caricris.com/pdfs/article/evolutionpart1.pdf.
modern portfolio management techniques, which require consistent quantitative

inputs across a wide range of financial instruments, and the increased use of
specific rating thresholds in financial market regulation, which are applied
uniformly without regard to the bond market sector.5 In a similar
pronouncement in 2001 Standard & Poors stated their approach, in both policy
and practice, is intended to provide a consistent framework for risk assessment
that builds reasonable ratings consistency within and across sectors and
geographies.6
Whether issuing institutions were corporations, municipalities, sovereign
nations or other such issuers, they were ongoing concerns sensitive to
developments within markets and within the institution. The CRAs analysis
emphasized the expected cash flow generated by the obligors ongoing business
in determining the credit risk to the note-holder. There was little that a rated
entity could do to change their credit characteristics before the rating process.
Today, the agencies seem to be more circumspect in answering questions about
the comparability of ratings across geographies and products.
Since the 1970s, largely due to issuer demand for ratings as a way to increase
investor confidence, the rating agencies revenues have increasingly been
generated by issuers of securities.7 In the past few years, these revenues have
been increasingly driven by ratings for relatively newer structured finance
products. As a result rating definitions have undergone significant changes to
their meaning as well as the manner in which they are employed. These changes
and their implications to the integrity of the rating process are significant.
In an effort to meet market demands for investment grade assets with higher
yields, the rating agencies created new models and approaches to rating these
assets. Given the limited number of Nationally Recognized Statistical Rating
Agencies (NRSROs) and requirements directing certain investors to purchase
only investment grade rated assets, their move to rate newer asset classes
strengthened their market power,8 or in the words of one rating industry
executive, their partner monopoly.9 As highlighted by the table below,
structured-financial products became a major growth opportunity for the ratings
5. Nomura, Bond Rating Confusion, June 29, 2006, at 2 [hereinafter Rating

Confusion].
6. Id.
7. STEPHANE ROUSSEAU, ENHANCING THE ACCOUNTABILITY OF CREDIT RATING
AGENCIES: THE CASE FOR A DISCLOSURE-BASED APPROACH 11 (2005), available at
http://www.rotman.utoronto.ca/cmi/papers/CRA_Study_Rousseau.pdf.
8. Amelie Champsaur, The Regulation of Credit Rating Agencies in the U.S. and
the E.U.: Recent Initiatives and Proposals 10 (May 2005) (unpublished LL.M.
dissertation, Harvard Law School), available at
http://www.law.harvard.edu/programs/pifs/pdfs/amelie_champasaur.pdf.
9. Letter from Sean J. Egan & W. Bruce Jones, to Jonathan G. Katz, Secretary,
United States Securities and Exchange Commission (Nov. 10, 2002), available at
http://www.egan-jones.com/sec_letter.aspx (In the case of most US corporate ratings
and an increasing number of structured finance transactions, S&P and Moodys are the
only firms used. The industry could more accurately be described as a "partner
monopoly", a term used by U.S. Department of Justice personnel. A partner monopoly
differs from an oligopoly in the sense that the two firms share the market whereby the
gain in revenues by one firm does not reduce the revenues of the second firm. Since two
ratings are normally needed for the issuance of bonds, the gains of Moody's do not come
at the expense of S&P and vice versa.).
industry and has become an increasing proportion of their revenues.
FIGURE 7: GLOBAL STRUCTURED FINANCE ISSUANCE IS GROWING RAPIDLY
Source: Moodys Corporation, Investor Presentation (March 2007), available at

http://library.corporate-ir.net/library/12/123/123831/items/236937/MCO%20March%20Long%20
FINAL.pdf
FIGURE 8: QUARTERLY REVENUE BY SEGMENT: Q1 2002 TO Q4 2006
Source: Moodys Corporation, Investor Presentation (March 2007), available at

http://library.corporate-ir.net/library/12/123/123831/items/236937/MCO%20March%20Long%20
FINAL.pdf
The concentration of rating agency power is not limited to the structured

finance market and extends into traditional credit rating business. However,
unlike other debt markets where the number of issuers allows for the broad
diversification of operational and model risk,10 there is a significant concentration
10. Bank for International Settlements, Committee on the Global Financial System,
The Role of Ratings in Structured Finance: Issues and Implications 24 (Jan. 2005)
(Model risk is not confined to structured finance. However, given the lack of
historical default data and the analytical challenges in assessing credit risk exposures (e.g.
in structured finance. For example, a recent report by the French securities

regulator pointed out that 12 banks account for more than 70 percent of
European deals, and three rating agencies cover the entire market (two of them
accounting for 80 percent). According to 2005 figures for the French market,
three legal firms account for more than 60 percent of the legal structuring work in
the CDO market, and three others account for more than 50 percent of volume in
the RMBS market.11 This concentration could have the effect of amplifying
rating model risks, the risks to legal structures, other legal risks, counterparty
risks, and the risks of misapplications of accounting rules (particularly FAS-140).
Moreover, traditional corporate bond ratings have long a long history of
application and have been empirically tested through various economic cycles.
Many structured products notably CDOs have not. According to the Bank for
International Settlements Committee on the Global Financial System, the risks
associated with structured products may not have been fully grasped by some
investors. 12
The move to securitize assets has largely been driven by lenders desires (for
capital purposes) to move assets off their balance sheet. The largest market for
securitized assets, however, is constrained to invest in only ERISA-eligible
securities, i.e., securities rated investment grade by the NRSROs. Hence the
market for securitized loans has developed as a rated market, which has been
facilitated by rating agencies willingness to rate securitized assets. 13
Bank capital declined as the market for securitized loans evolved.14 This was
treatment of correlation, recoveries and time variation), it is likely to be a more important

issue in the credit risk than in the market risk world. This applies, in particular, for
structured finance instruments, as in the case of correlation assumptions discussed above.
As a result, model-based risk assessments can be a long way from true values and, to
the extent that investors rely on ratings for their structured finance investments, the model
risk linked to the agencies rating methodologies will be among the principal risks these
investors are exposed to.) [hereinafter Role of Ratings].
11. France, Authorite des Marches Financiers, Research Department, Aguesse,
Partice Is Rating an Efficient Response to the Challenges of the Structured Finance
Market?, 8 (Mar. 2007).
12. Bank for International Settlements, Committee on the Global Financial System,
Incentive Structures in Institutional Asset Management and their Implications for
Financial Markets 7 (Mar. 2003) [hereinafter BIS Study]. (Similarly, with consensus on
best practice regarding the modeling of portfolio credit risk still lacking, model risk
in instruments such as collateralised debt obligations (CDOs) is an issue for even the
most sophisticated market participants. Use of structured finance instruments, together
with the occurrence of worst case scenarios relating to mispriced or mismanaged
exposures, might thus lead to situations in which extreme market events could have
unanticipated systemic consequences. Given these issues and the fact that structured
finance markets are still largely untested, continued growth in structured finance activity
warrants ongoing central bank awareness.).
13. Role of Ratings, supra note 10, at 2 (From the beginning, structured finance has
largely been a rated market. Issuers of structured instruments apparently wanted them
to be rated according to scales that were identical to those for bonds, so that investors,
some of whom were bound by the ratings-based constraints defined by their investment
mandates, would be able and willing to purchase the new products.).
14. Katherine Samolyk, The Evolving Role of Commercial Banks in U.S. Credit
Markets, FDIC FUTURE OF BANKING STUDY 43 (2004), available at
http://www.nubank.com/NBI/fdic-evolving-role_06-01-04/fdic_fob_01.pdf.
generally a positive movement for lenders, but as competition for loans increased
the profitability of traditional lending decreased.15 Hence, securitization became
a driver for new mortgage product development, which helped increase
homeownership rates and home prices in the past decade.
The changes in the role of rating agencies, as their business has evolved from
the rating of dynamic and on-going enterprises to static and defined-lived
structured assets, warrants inquiry into not only the rigors of their structured
finance rating models but also their historic claims of being publishers protected
by the First Amendments protections of the freedom of the press.16 Historically
rating agencies have claimed that their letter-grade ratings were merely an
opinion of the creditworthiness of an issuer or, according to a Fitch general
counsel, the worlds shortest editorial.17 Courts have found that ratings are
speech and, absent special circumstances, are protected by the First
Amendment [and] as a matter of public concern, would receive the heightened
protection of the actual malice standard.18 Given the changing nature of their
business and compensation there may be reason to question whether, today, they
should be viewed as editorializing or advertising.
B. Are Credit Rating Agencies Still Publishers or Are They Underwriters?
The Senate Commerce Committee offered the following opinion in its Enron
report: The credit rating agencies seem to be trying to walk a fine line between
maintaining enormous market power through both official and unofficial uses of
their ratings, and insisting that their ratings are purely their opinion, and
therefore pure speech under a First Amendment analysis.19 Although the authors
do not claim legal expertise, there are clear reasons to consider whether, in
structured finance, the commercial speech of the CRAs would be protected upon
a challenge.
Rating agency claims of being publishers is called into question, by
implication, in a recent report to the European Commission of Securities
Regulators The CESR highlighted several areas where the rating agencies were
either not in compliance with the code or were questionably in compliance
16. Id.
16. See, e.g., Exposure to Litigation Related to Moodys Rating Opinions,
http://sec.edgar-online.com/2007/03/01/0001193125-07-043002/Section2.asp (last visited
Apr. 30, 2007) (Moodys faces litigation from time to time from parties claiming
damages relating to ratings actions. In addition, as Moody's international business
expands, these types of claims may increase because foreign jurisdictions may not have
legal protections or liability standards comparable to those in the U.S. (such as
protections for the expression of credit opinions as is provided by the First Amendment).
These risks often may be difficult to assess or quantify and their existence and magnitude
often remains unknown for substantial periods of time.).
17. Financial Oversight of Enron: The SEC and Private-Sector Watchdogs Report of
the Staff to the Senate Committee on Governmental Affairs Oct. 8, 2002 [hereinafter
Financial Oversight of Enron].
18. See, e.g., County of Orange v. McGraw Hill Cos., Inc., 245 B.R. 151, 156 n.4
(C.D. Cal. 1999).
19. Financial Oversight of Enron, supra note 17, at 123.
with the code.20 Although the rating agencies seemed to be compliant with Code
1.1 under Quality and integrity of the rating process, the manner in which they
complied appears not to meet journalistic standards of ethics.21 The IOSCO Code
explains that the CRA should adopt, implement and enforce written procedures
to ensure that the opinions it disseminates are based on a thorough analysis of all
information known to the CRA that is relevant to its analysis according to the
CRAs published rating methodology.22 In its submissions, Fitch submitted that
Fitch shall have no obligation to verify or audit any information provided to it
from any source or to conduct any investigation or review, or to take any other
action, to obtain any information that the issuer has not otherwise provided to
Fitch.23 Although Moodys submission in answer to their relevant policy was
not direct, it appears that they also fall short of journalistic standards.24
Beyond the issues raised specifically by the CESR staff, there may be reason to
question the spirit with which one or more agencies comply with other provisions
of the code.25 It is not clear whether an agencys decision to recuse itself of the
responsibility to verify information provided by an issuer fully meets the implied
standard. Nor is it clear whether such conduct falls short of the standards the
agencies are expected to meet as investment advisors under the 1940 Act?26
20. CESR Code 1.15, 2.5, 2.12, and 3.9.

21. Society of Professional Journalists, available http://www.spj.org/ethicscode.asp
(last visited Apr. 30, 2007).
22. Committee of European Securities Regulators Report to the European
Commission on the compliance of credit rating agencies with the IOSCO Code - Ref:
CESR/06-545 at 13 available at http://www.cesr-eu.org/data/document/06_545.pdf.
23. Id. at 21.
24. Moodys Investor Service, Code of Professional Conduct 6 (June 2005),
available at http://www.moodys.com/cust/research/MDCdocs/01/
2003400000425277.pdf (Moodys has no obligation to perform, and does not perform,
due diligence with respect to the accuracy of information it receives or obtains in
connection with the rating process. Moodys does not independently verify any such
information. Nor does Moodys audit or otherwise undertake to determine that such
information is complete. Thus, in assigning a Credit Rating, Moodys is in no way
providing a guarantee or any kind of assurance with regard to the accuracy, timeliness, or
completeness of factual information reflected, or contained, in the Credit Rating or any
related Moodys publication.).
25. THE COMMITTEE OF EUROPEAN SECURITIES REGULATORS, CESRS REPORT TO
THE EUROPEAN COMMISSION ON THE COMPLIANCE OF CREDIT RATINGS AGENCIES WITH
THE IOSCO CODE 1 at 13, 1.2 at 14, 1.9 at 21, 1.14 at 26, 2.1 at 31 (Dec. 2006), available
at http://www.cesr-eu.org/data/document/06_545.pdf [hereinafter CESRs Report to EC].
(See e.g. Section 2.1: not forbear or refrain from taking a rating action based on the
potential effect (economic, political, or otherwise) of the action on the CRA, an issuer, an
investor, or other market participant. And, Section 1.14 not either implicitly or
explicitly, give any assurance or guarantee of a particular rating prior to a rating
assessment. This does not preclude a CRA from developing prospective assessments used
in structured finance and similar transactions.).
26. See, e.g. Memorandum from Annette L. Nazareth, Director, Division of Market
Regulation, United States Securities and Exchange Commission, to William H.
Donaldson, Chairman, Securities and Exchange Commission 4 (June 4, 2003), available
at http://www.sec.gov/spotlight/ratingagency/baker060403.pdf. (The Commission has
emphasized that, NRSROs, as registered investment advisers under the Investment
Advisers Act of 1940 (the Advisers Act), have a special duty to base their opinions
upon current and adequate information.) [hereinafter Nazareth Memo].
The need for rating agencies to objectively assess and verify information rises in
structured finance transactions since, unlike the traditional ratings process in
which an enterprise can do little to change its risk characteristics in anticipation
of an issuance, in structured finance, the rating agency is an active part of the
structuring of the deal.27 In practice, arrangers will routinely use the rating
agencies publicly available models to pre-structure deals and subsequently
engage in a process that is iterative and interactive,28 informing the issuer of
the requirements to attain desired ratings in different tranches and largely
defining the requirements of the structures to achieve target ratings.293031
27. Timothy J. Riddiough & Risharng Chiang, Commercial Mortgage-Backed

Securities: An Exploration into Agency, Innovation, Information, and Learning in
Financial Markets, 1 (2003), available at
(http://scholar.google.com/scholar?hl=en&lr=&safe=off&q=cache:tgPHB82FijQJ:www.
nchu.edu.tw/~Fin/03_research/fin2003/Commercial%2520Mortgage-
Backed%2520Securities.pdf+riddiough+chiang+Commercial+Mortgage-
Backed+Securities. (instead of assuming a passive credit quality certification role, the
rating agency actively controls security architecture and are instrumental in determining
product design standards.).
28. Taiwan Ratings, http://www.taiwanratings.com/en/criteria/SF_ratingprocess.asp
(last visited Apr. 30, 2007).
29. Letter from John R. Rutherford, to Nancy M. Morris, Secretary, Securities and
Exchange Commission (Mar. 8, 2007), available at http://www.sec.gov/comments/s7-04-
07/s70407-17.pdf. (Normally sponsors of structured products seek to achieve specified
rating levels for the various issues of securities (tranches) backed by the assets in the
structure. They engage in iterative discussions with a rating agency. The sponsors
propose specified assets and structures of seniority within the tranches to achieve the
desired rating levels, and the rating agency indicates whether or not the specified assets
and structures achieve those rating levels consistent with the methodologies of the rating
agency The most frequent situation where a rating agency does not rate the securities
of a structured product is when the proposed assets and structures of the issuer and the
proposed ratings of the sponsor do not meet the credit requirements of the rating agency
following its specified methodologies. Normally, in this situation another credit rating
agency, which may be an NRSRO, has concluded that the proposed ratings of the sponsor
do meet the credit requirements of such agency. In this manner, sponsors of structured
products shop for the ratings they desire.);
30. Role of Ratings, supra note 10, at 2. (What distinguishes the rating of
structured finance transactions from the rating of traditional instruments is that the former
requires the rating agencies to be involved in the deals structuring process. This is
because a tranche rating reflects a judgment about both the credit quality of the
underlying collateral asset pool and the extent of credit support that must be provided
through the transactions structure in order for the tranche to receive the rating targeted
by the deals arrangers. Deal origination thus involves obtaining implicit structuring
advice by the rating agencies, at least to the extent that arrangers use rating agency
models to pre-structure deals and subsequently engage in an iterative dialogue with the
agencies in order to finalize these structures. As a result, ratings of structured finance
instruments have a decidedly ex ante character. This contrasts with traditional bond
ratings, where pre-rating discussions between issuers and agencies play a more limited
role.).
31. Authorite des Marches Financiers, Research Department, Is Rating an Efficient
Response to the Challenges of the Structured Finance Market?, March 2007, at 6
(Rating is an integral part of structuring securitization products. The agency is involved
at an early stage, and the rating is not an outcome but a target for the arranger, with the
Because RMBS-based CDOs are generally comprised of lower- grade

tranches of RMBS, it seems that the role of rating agencies is a necessary
function of their sale and distribution. While that is not to say that no investors
would purchase the senior assets without ratings, rating agency approval still
appears to determine the marketability of a given structure to a wider market.32
It is possible that the ratings process may be considered essential to the ability
of an issuer to sell the desired assets. Should agencies be therefore considered as
underwriters? Are agencies possibly in a control position with the practical
ability to direct the actions of the people who issue or sell the securities?33
According to the 1933 Securities act the term underwriter includes any
person who has a direct or indirect participation in any such undertaking, or
participates or has a participation in the direct or indirect underwriting of any
such undertaking34 It seems plausible there may be a basis for argument that
they have participated in the underwriting. Congress knew of the collateral
participation concept and employed it in the Securities Act . . .The Court's
footnoted discussion makes clear that, in its view, one who participates, or
takes part in, an underwriting is subject to section 11 liability.35 While it is not
completely clear if the role played by a CRA would fall under that definition,
there does seem to be some basis to consider that risk since the term underwriter'
is broad enough to encompass all persons who engage in steps necessary to the
distribution of securities.36
The ex ante contractual nature of a structured finance rating transaction, as
contrasted with a traditional rating process, allows arrangers to adapt the profile
of a tranche in response to pre-rating feedback. Therefore, the essential role the
rating agencies play gives reason to question whether their asserted and legally
upheld37 freedom of the press protection would be upheld were it challenged in
relation to a structured finance transaction.
Rule 436(g) of the 1933 Securities Act exempts the NRSROs from expert
liability under Section 11, as they are not considered experts in regard to ratings
inclusion in a registration statement.38 The agencies routinely advise buyers of
agency indicating the factors that need to be addressed to obtain the desired rating. In
particular, the agency has an indirect influence on how the tranches are configured to
ensure that the senior issue obtains the highest possible rating.) [hereinafter Authorite
des Marches Financiers Report]
32. Role of Ratings, supra note 10, at 38.
33. John S. Dzienkowski & Robert J. Peroni, The Decline in Lawyer Independence:
Lawyer Equity Investments in Clients 80 n.353 (2002), available at
http://www.law.fsu.edu/faculty/2001-2002workshops/dzienkowski.pdf.
34. Securities Act of 1933 2(a)(11), available at
http://sec.gov/divisions/corpfin/33act/sect2.htm.
35. Naomi O. Harden et al. v. Raffensperger, Hughes & Co., Inc., 94 U.S. 2892 (7th
Cir. 1995), available at http://caselaw.lp.findlaw.com/cgi-
bin/getcase.pl?court=7th&navby=case&no=942892.
36. Harden v Raffensperger, Hughes & Co., Inc., available at
http://caselaw.lp.findlaw.com/scripts/getcase.pl?court=7th&navby=case&no=942892.
37. Memorandum from Cahill Gordon & Reindel LLP on the constitutionality of
H.R. 2990, the Credit Rating Agency Duopoly Relief Act of 2005 8 (July 2005),
available at http://www2.standardandpoors.com/spf/pdf/media/Exhibit_2.pdf.
38. 17 C.F.R. 230.436.
securities of this fact.39 It is, however, unclear whether the SECs exemption is
within the boundaries of Congressional intent given the fundamental changes in
the use of ratings since they were given such protection.40
Moreover, if a rating agencys role in an issuance were determined to move
beyond the traditional role of publishing opinions and extended to being
determined an underwriter their liability could become tied to any liabilities of
any other underwriter of the transaction.41
Current problems in the subprime market, the bankruptcies and therefore loss
of some of the former industry deep pockets, discussions in Congress of
assignee liability, and the myriad accounts of mortgage fraud on the part of
some lenders and some borrowers suggest that litigation against many of the
potentially participant parties will be among the possible responses to the
current crisis. With the majority of lower-rated RMBS tranches having been
bought, primarily by Collateralized Debt Obligations and subprime RMBS
exposures in CDOs averaging close to 45 percent4243 it is ironic that in a recent
hearing of the Senate Banking Committee titled Subprime Mortgage Market
Turmoil: Examining the Role of Securitization, there was no mention in the
written testimony by either Moodys or S&P, of this very profitable CDO
segment of their business.44
Perhaps another means to better define precisely the role CRAs play in some
structured-finance issues would be to consider their interactions with other
engaged parties who are also paid by the issuing client. In structured finance
transactions, legal isolation is usually a key consideration. Part of the rating
39. See, e.g. FitchRatings Terms of Use,

http://www.fitchratings.com/jsp/corporate/TermsOfUse.faces?context=3&detail=2 (last
visited Apr. 30, 2007). (The assignment, publication, or dissemination of a rating by
Fitch shall not constitute a consent by Fitch to use its name as an expert in connection
with any registration statement filed under the United States securities laws, the Financial
Services and Markets Act of 2000 of Great Britain, or the securities laws of any particular
jurisdiction.).
40. Nazareth Memo, supra note 26, at 4 n.6.
41. Securities Act of 1933 11. 77k(a), available at
http://www.sec.gov/about/laws/sa33.pdf. See e.g (In case any part of the registration
statement, when such part became effective,1contained an untrue statement of a material
fact or omitted to state a material fact required to be stated therein or necessary to make
the statements therein not misleading, any person acquiring such security (unless it is
proved that at the time of such acquisition he knew of such untruth or omission) may,
either at law or in equity, in any court of competent jurisdiction, sue(5) every
underwriter with respect to such security.).
42. CreditFlux, Fitch quantifies ABS CDO exposure to subprime (Apr. 2, 2007),
available at http://www.creditflux.com/digest/2007/04/02/fitch+quantifies+
abs+cdo+exposure+to+subprime.htm.
43. Alistair Barr, Mortgage crisis to hit holders of risky derivatives,
MARKETWATCH (Apr. 2, 2007), available at
http://www.marketwatch.com/news/story/whos-winning-lose-subprime-
shakeout/story.aspx?guid=%7B20967453-D958-4D99-B40B-9C0E80FC036%7D&dist=.
44. Subprime Mortgage Market Turmoil: Examining the Role of Securitization
Before the S. Comm. on Banking, Housing, and Urban Affairs, 110th Cong. (2007),
available at http://banking.senate.gov/index.cfm?Fuseaction=Hearings.
Detail&HearingID=256.
agencies role is to assess the documentation and legal structure of a proposed

deal. Just as the arranger/client and their lawyers must be especially diligent in
the assessment of legal structure, so too must the rating agencies. Rating
agencies do not always use outside counsel, they ask, on a regular basis and for
information purposes, arrangers lawyers to give them some of the analysis
originally destined for the arrangers on questions that concern all parties. There
are few lawyers involved in the structured finance sector, and in the event a law
firm acts for different participants on the same deal, there could be a potential
conflict of interest.45
Although it does not seem likely or supportable, another conceivable view of
their role may be that, unlike traditional rating processes where a deals terms are
fairly well structured prior to the engagement of a rating agency, in the
structured-finance-rating process, the agencies consider all of their work to be
hypothetical and not deal-specific up to the point of a final execution.46
FIGURE 9: MOODYS STRUCTURED FINANCE RATING APPROACH
Source: Moodys Investors Service, Russian RMBS and Rating Process Overview (Oct. 4,
2006), available at http://www.ifc.org/ifcext/rpmmdp.nsf/AttachmentsByTitle/
Moody's+Presentation+1+Eng/$FILE/Microsoft+PowerPoint+-+1_Russian+RMBS+
Developments+(IFC+Moscow+Seminar).pdf.
45. Authorite des Marches Financiers, supra note 31, at 9

46. Letter from Deloitte & Touche LLP, to Jonathan G. Katz, Secretary, Securities
and Exchange Commission (June 18, 2004), available at
http://www.sec.gov/rules/policy/s72204/deloitte061804.pdf. (For example, AU 625
makes a distinction between specific transactions and hypothetical transactions. Certified
public accountants are precluded from issuing written reports on the application of
accounting principals to a hypothetical transaction (paragraph .04). In our experience, as
the customer and the financial institution evaluate a complex structured transaction, the
terms of the modified again, in an iterative process, sometimes up to the point of
execution. Some certified public accountants and their clients consider such transactions
hypothetical until they are consummated.).
C. New ConflictsThe Buy Side
While portfolio selection is generally considered to be efficient and driven by

an investors expectation of absolute returns relative to acceptable levels of risk,
competition often stimulates a race to the bottom where investors ability to
accumulate assets is driven by relative return, thereby requiring some managers
to purchase assets that may be more risky that they would otherwise choose.47
These behaviors were common in the Internet stock boom of the late 1990s and
drove herding behaviors among an increasing number of investors whose
momentum strategies fueled asset price increases that were seemingly not
fundamentally grounded in considered risk price premiums.
Investor demand for investment grade assets with higher yields, coupled with
lender desire to reduce portfolio exposures, supported the agencies move to
create new models and approaches allowing them to rate new structured finance
assets. This further supported the rating dominance of Moodys, S&P and Fitch
on a global basis.48 These models were created in close cooperation with the
investment banks that structured CDOs.49 By creating models to rate CDOs, the
agencies provided issuers a way to reconfigure sub-investment grade assets into
investment grade tranches of new structured products that would offer a higher
yield at a presumably reduced credit risk.
Unlike the traditional rating process for single-named issuers, which rely on
empirical analysis at their core, structured-finance rating analysis is essentially
driven by statistical models. Even in the relatively short history of CDOs,
changes of rating are statistically larger and more frequent than those for
corporate ratings or ABS, and the rating process appears to be at risk for potential
rating arbitrage by banks.50 It is also worth noting that Moodys structured
finance rating migrations are more likely to entail moves of several notches at a
47. BIS Study, supra note 13, at 49 (To avoid falling behind their peer group, they
then have incentives to trade with the crowd (reputation-based herding) to avoid the
reputational risk of acting differently from their peers (Scharfstein and Stein (1990)).
Similarly, herding can be compensation-based (Maug and Naik (1996)) when fee
contracts for delegated portfolio managers contain relative performance elements.
Second, institutions might infer private information about the quality of investments from
each others trades (as in Banerjee (1992) and Bikhchandani et al (1992)). Third,
institutional investors might trade together simply because they receive correlated private
information from analyzing the same indicators (Froot et al (1992)).).
48. JPMorgan, CDO Handbook 28 (May 29, 2001), available at
http://www.mathematik.uni-
ulm.de/finmath/ss_05/fe/JPMorganCDOHandbook.pdf. (See e.g S&P pioneered
market value CDO ratings in 1987 and cash flow ratings in 1988. By 1990, however,
Moodys dominated the rating of cash flow structures due to rating standards that more
flexibly addressed a wider range of portfolio credit quality and diversity. Beginning in
1996, Fitch began rating the second generation of market value CDOs. Moodys and S&P
came out with revised market value requirements in 1998 and 1999, respectively, and
became more active in that market.).
49. Frank Partnoy, How and Why Credit Rating Agencies Are Not Like Other
Gatekeepers 21, available at http://www.tcf.or.jp/data/20050928_Frank_Partnoy.pdf.
50. Authorite des Marches Financiers, supra note 31, at 10.
time, compared to an average change of about 1.5 notches for corporate bonds.51
Having not been tested in a sustained period of economic volatility or economic
stress, it is unclear if the approaches employedwhich use computer simulations
to ascertain incidence of breaches in a tranches structure and not the severity of
those breaches52is an appropriate methodology.
Whether the rating of these reconfigured assets from sub-investment-grade
residential mortgage-backed securities to investment-grade tranches in CDOs is
the result of true diversification of risk or the result of rating agency alchemy is
unclear.53 What is clear is that the lack of liquidity, transparency, history and
available data coupled with unprecedented complexity has made it difficult for
all but the most well funded, well staffed and most sophisticated to analyze the
markets or assets. This has further increased market reliance on the CRAs.5455
This reliance is strikingly different from the traditional assets a rating agency
rates. Where a charter constrained investor disagrees with a rating agencys
assessment of a particular corporate issue it can avoid that issue and find other
issues within the desired asset class where it does agree with the rating. The more
active role of the rating agencies in structured finance, the essential oligopolistic
structure of the industry, the reality that their ratings are required for the sale of
investment grade structured finance securities and the theoretically consistent
application of their rating methods may mean that an investor who disagrees with
the rating agencies approach to structural risk rating is often precluded from any
investments in an entire asset class.56
51. John Ammer & Nathanael Clinton, Good News Is No News? The Impact of
Credit Rating Changes on the Pricing of Asset-Backed Securities (Board of Governors of
the Federal Reserve System International Finance Discussion Papers No. 809, Jul. 2004),
available at http://www.federalreserve.gov/pubs/ifdp/2004/809/ifdp809.htm#foot36.
52. Partnoy, supra note 49, at 22 (Although this process employs sophisticated
mathematical techniques, the conclusions can be somewhat dubious. For example, a
rating agency might run 100,000 computer simulations to determine the number of times
a breach would occur, that is, how often a particular tranche would lose value beyond a
certain level. However, the variable in this assessment is the number of breaches out of
the 100,000 runs, not the magnitude of the breach or any qualitative analysis of the
breach.).
53. Frank Partnoy & David A. Skeel Jr., The Promise and Perils of Credit
Derivatives 12 (University of Pennsylvania Law Sch. Working Paper No. 125, 2006),
available at http://lsr.nellco.org/cgi/viewcontent.cgi?article=1129&context=upenn/wps.
54. Authorite des Marches Financiers, supra note 31 (Due to the complexity of the
deals and the diversity of underlying assets involved, most investors (except investors in
junior or highly subordinated tranches) do not have dedicated credit analysts to properly
assess structured deals. As a result, many investors rely on rating agencies to assess the
quality of each structure, both at initiation and throughout the life of the transaction.).
55. BIS Study, supra note 13, at 44 (Overall, investors appeared to hold the view
that rating agencies are more important for structured finance than for traditional debt
instruments. Interviewees cited several factors at play: the rating agencies role in
modeling the risks of complex structured finance instruments; their key role in deal
structuring; and a clear information advantage, in particular over less sophisticated
investors. An important reason for the reliance on ratings seems to be that many client
mandates and internal investment guidelines prescribe minimum rating levels.).
56. SEC Hearings on Issues Relating to Credit Rating Agencies (Nov. 21, 2002)
(statement of Amy Lancellotta, Senior Counsel, Investment Company Institute, available
at http://ici.org/issues/dis/02_sec_2a-7_stmt.html [hereinafter Lancellotta Statement].
As a result of this increasing complexity and opacity and the difficulties of

investors in analyzing and pricing structured-finance assets and their risks, recent
new business initiatives by CRAs have focused on providing valuation services
to buy side clients. This may further exacerbate potential conflicts of these
organizations. Given the CRAs involvement in defining the pre-issuance
structures of CDO deals, defining the collateral and, implying appropriate yields
to tranches of structures are they well suited to offering products that value
securities, in the secondary market which they may have rated at issuance.57
Fitch has recently rolled out a product that provides present values, risk
and a complete scenario stress testing environment Risk can be run across an
entire portfolio of deals to calculate book-level hedging requirements.58 The
statement that investors using RAP CD get full access to Derivative Fitchs in-
house team of quants and market risk specialists, thereby enabling them to out-
source the entire CDO risk management process to third party experts59 seems
to raise further questions about the corporate and business line firewalls that
separate the rating business from their various advisory services.
D. The Problems With Ratings In Structured FinanceEvolving Models
In a 2005 report from the Bank for International Settlements Committee on

the Global Financial System the three major rating agencies (Fitch, Moodys and
Standard & Poors) were reported to claim all products they are asked to rate are
subject to a common rating processIn addition, all ratings are ultimately
mapped into an alphanumeric scale benchmarked to the historical performance of
corporate bonds.60
This claim does not appear to properly reflect current market realities either
in theory or practice. There is increasing evidence that the ability to use rating
scales for comparability even within some asset-classes has potentially become
compromised. Frequent changes to structured finance rating methodologies
coupled with the apparent inconsistencies in the application of these ratings
criteria between new and existing structured-finance asset classes may
significantly impair both the integrity of rating scales and support undue risk
taking.
Today, although the scales used to measure disparate asset classes remain the
same, the implied default risks of those ratings are different for different asset
57. Authorite des Marches Financiers, supra note 31, at 9. (See e.g Since 2005,
several rating agencies have proposed pricing services for the secondary market of
existing deals. To the extent that rating agencies are the sole decision makers for any
rating changes and due to the asymmetry of information between rating agencies and
market participants in this area where ratings constitute an essential if not exclusive basis
for setting a price, such a new service could raise questions about the information used by
rating agencies to provide market prices, and the mix of responsibilities this might create
between their role as rating entity and their presence in the secondary market for the
valuation of the rated paper.).
58. STRUCTURED CREDIT INVESTOR, Feb. 2, 2007, available at
http://www.structuredcreditinvestor.com/story.asp?PubID=250&ISS=22088&SID=15658
(People haven't addressed the market risk side of the deal.).
59. Id.
60. Role of Ratings, supra note 11, at 14.
classes.61 Uncertainty about the meaning of original ratings is significant62and the

meaning of ratings in secondary markets is similarly uncertain. Can specific
structured finance products with a AAA credit rating produce a return of up to
200 bp for investors, while a AAA corporate or a AAA RMBS tranche produces
only a 10/20 bp return? What does that mean? A market imperfection, a new
product premium, a liquidity premium? Or the market perception that the risk
attached to this AAA tranche, especially in terms of volatility, is higher than for a
"standard" transaction?63
Finding the correct answers to these questions may be fundamental to the
integrity of financial markets and, as importantly, to the proper assessment of
bank capital requirements. Under the Basel II framework banks can use ratings in
determining the risk weights in the Standardized Approach as long as the issuing
rating agency is recognized by that nations banking regulators.64 This delegation
of bank supervisory power to the NRSROs has existed in the U.S. banking
industry prior to the Basel II guidance65 and some regulators even assign which
rating agencys models are to be employed.66
In January of 2006 the Community of European Banking Supervisors issued
Guidelines on the recognition of External Credit Assessment Institutions in
which it recognized the risk of ratings migration and the need to be able to assess
not only original rating analysis but a cohort approach that incorporates the
effect of ratings migration which should include rating migration.67
61. Rating Confusion, supra note 5 (For example, according to S&P, a rating of
"BBB" corresponds to a five- year default probability of 1.255% for asset backed
securities, but a higher default probability of 2.323% for corporate bonds. Likewise, a
rating of AA corresponds to a seven-year default probability of 0.315% for ABS,
0.420% for corporate bonds, and 0.701% for CDOs . At Moodys, municipal bond ratings
correspond to half the level of expected loss as corporate bond ratings for purposes of
rating CDOs. Inconsistent definitions make it hard for investors to use ratings to compare
the credit risk in different kinds of securities.).
62. Authorite des Marches Financiers, supra note 31, at 13. (See e.g In light of the
constant flow of new innovative structured products, questions should be raised at the
European level concerning the potential limitations of agencies' models - can everything
really be rated? and the meaning of ratings. This should be done in close cooperation
with the prudential authorities in charge of the implementation of Basle II and of the
OEEC regime, with the principal objective of encouraging understanding among the
participants and strengthening the market's credibility. It is also necessary to determine if
a structured finance rating is equivalent to a corporate rating and, within securitization
ratings, whether or not the rating of a cash CDO is equivalent to the rating of a synthetic
CDO. In this respect, is there a need for either differentiating structured finance and
corporate ratings or for requiring additional information regarding the volatility or
sensitivity attached to each structured finance rating, which, for certain products like
CDOs.)
63. Id.
64. COMMITTEE OF EUROPEAN BANKING SUPERVISORS, GUIDELINES ON THE
RECOGNITION OF EXTERNAL CREDIT ASSESSMENT INSTITUTIONS 1 (Jan. 20, 2006),
available at http://www.bundesbank.de/download/bankenaufsicht/pdf/cebs/GL07.pdf
[hereinafter Guidelines on External Credit].
65. See 12 C.F.R. 955.3(a), (b).
66. Letter from Stephen M. Cross, Director, Office of Supervision, Federal Housing
Finance Board, to Federal Home Loan Bank Presidents and Directors of Internal Audit
(Aug. 12, 2004), available at http://www.fhfb.gov/GetFile.aspx?FileID=68.
67. Guidelines on External Credit, supra note 64, at 161.
With frequent adjustments to their structured finance models there seems to

be an implicit recognition of the inability to define stable measures of significant
issues 68 such as default correlation risk.
In an effort to keep up with rapid developments in structured finance markets
the agencies claim to be constantly improving their methodologies.69 In Europe
alone during 2004, two of the three major rating agencies published 57 releases
detailing changes in their rating methods. Of those changes 45 related to ABS
and the other 12 related to CDOs.70 Fitch seemed to acknowledge the wild west
aspects of the CDO and credit derivatives markets when they wrote 2007 holds
much promise for the global CDO and credit derivatives arena as novel methods
of packaging risks and analytical models emerge and new players join this
growing bandwagon. The lack of transparency makes it difficult to determine
whether these adjustments, in part or in aggregate, would have a meaningful
impact to existing structures.71
Deng and Sanders point out that the rating agencies follow a learning by
doing approach to determining the required subordination levels in structured
finance deals.72 While this research suggests that the levels of required
subordination has been, conservative during the relatively short history of these
assets, it also points out that in the process of learning by doing the agencies
have reduced subordination levels. It is not clear whether these subordination
levels will prove to be conservative in a downturn.
The fact that CDOs and other complex credit derivatives remain largely
illiquid and nontransparent73 may only serve to amplify structural weaknesses in
68. Authorite des Marches Financiers, supra note 31. (See e.g. Due to pressure and
competition, rating agencies may be asked to rate complicated and innovative (though
well remunerated) deals within a very short time, which despite all the due process can
potentially lead to errors or an approximate assessment of the risks involved.)
69. Authorite des Marches Financiers, Ratings in the Securitization Industry 16 (Jan.
2006) [hereinafter Ratings in Securitization Industry].
70. Id.
71. Ratings in Securitization Industry, supra note 69 (The agencies claim that,
statistically, methodological changes rarely lead to rating changes. Investors say that
SPVs sometimes receive significant downgrades, but it is difficult to say whether these
are partly attributable to methodological changes or solely reflect a deterioration in the
underlying asset pool.).
72. Xudong Yongheng Deng & Anthony B. Sanders, Subordination Levels in
Structured Financing, Oct. 30, 2006, at 2, available at
http://fisher.osu.edu/~sanders_12/Sub.pdf.
73. Randall S. Krozner, Governor, North Carolina, Remarks to the 2007 Credit
Markets Symposium at the Charlotte Branch of the Federal Reserve: Recent Innovations
in Credit Markets (Mar. 22, 2007), available at
http://www.federalreserve.gov/BoardDocs/Speeches/2007/20070322/default.htm (Along
with liquidity, transparency in credit markets has also improved over time. Corporate
bond markets are more transparent thanks to a regulatory change that took effect in 2002.
Dealers must now report nearly all corporate bond trades to the NASD within fifteen
minutes, and the NASD immediately reports the trade data to the market. For asset-
backed securities and loans, price transparency is available from specialist vendors who
aggregate and disseminate dealers prices. For example, in the syndicated loan market,
one vendor currently aggregates data from more than seventy traders to price nearly
6,000 loans daily. Prices of many credit derivatives, including single-name CDS, credit
the event of an unanticipated adverse event. Generally, when a rating agency

makes an adjustment to its models in structured finance, it rarely re-rates existing
assets.74 As a result, rated tranches with the same ratings but of different issuance
dates may have meaningfully different risk profiles.75 In December of 2006, Fitch
highlighted that the increased market for affordability products and the
regulatory scrutiny of those products. As a result they announced they had
increased credit enhancement levels. They went on to state that initial credit
enhancements required for AAA bonds issued in 2006 averaged 20 percent
more than for those issued in 2003.76
This may be of particular importance to the risks of cash-flow structures that
have a revolving period or to market-value structures. During the revolving
period principal proceeds can be reinvested in new assets so long as collateral
coverage tests are met. The collateral asset manager (CAM) for revolving
mezzanine structured finance CDOs can trade 15-20 percent of the CDOs
portfolio during the revolving period.77 If the rating agencies do not re-rate
structures or underlying assets upon changes in their methods this may create
significant opportunities for risky rating arbitrage by deal managers.
As a hypothetical example, assume the primary assets supporting a CDO
structure originated in 2005 were the equity tranches of subprime RMBS from
2003, 2004 and 2005. Now assume that in 2006 a rating agency made
adjustments to their models which tightened ratings by increasing required
collateral for all new issues. As the principal of the 2005 vintage CDO became
available for reinvestment, barring a re-rating, the CDO may be able to reinvest
in 2006 vintage assets without having to worry about increased collateral
requirements. As a result, the original 2005 vintage structure would be in a
position to purchase presumably less valued assets, with less required collateral
and receive a higher yield than a new structure would be able to. While we are
unaware of any studies addressing these issues conversations with retired rating
staff suggest that often the rating agency would merely require a standardized
50bp enhancement to the structure.
It is therefore not clear that rating agencies assessments would be considered
derivative indexes, and credit index tranches, are widely available on services such as
Bloomberg or Reuters. Complex credit derivatives such as CDO tranches are an
exception to all this: They remain largely illiquid and nontransparent.).
74. BIS Study, supra note 13, at 39. (The quality and availability of surveillance
data during the life of a structure were generally felt to be inadequate, especially in
Europe, though improving rapidly. Investors often rely on quarterly reports by the trustee
and the rating agency. Sometimes these are sent to the initial investor only. A few
investors also pointed out that, as a result of their fee structures, rating agencies
sometimes cared less about surveillance than about initial ratings.).
75. Ratings in Securitization Industry, supra note 69, at 16 (The agencies rate a
transaction when it is carried out. Published changes in methodology apply to future
transactions. However, the agencies do not take the same approach when updating ratings
for past transactions. Some of the agencies do not revisit the old ratings but use the new
method in their surveillance. Thus, the surveillance process is based on both the old and
new methodologies.).
76. FitchRatings, Credit Policy Special Report 2007 Global Structured Finance
Outlook: Economic and Sector-by-Sector Analysis December 11 2006 at 19
77. Rating Stability of Fitch-Rated Global Cash Mezzanine Structured Finance
CDOs with Exposure to U.S. Subprime RMBS, Apr. 2, 2007, at 11.
appropriate for risk-weighting analysis under Basel II.78 Market Value CDOs
are enjoying a revival with issuance more than doubling in 2006 from the year
before. MV CDOs appeal to managers because they offer greater trading
flexibility and can invest in a wide range of assets including high yield bonds and
bank loans and SF securities.79
In the wake of the recent credit problems in subprime residential mortgage
performance the rating agencies have issued research reports and held conference
calls with advise investors on the potential rating implications to both RMBS and
CDOs with subprime exposures. Many of the details of their analysis highlighted
potential risks to their assumptions.
In one of the more striking recent reports80 Moodys commented that it is
requesting increased levels of loan details from mortgage securitizers to enhance
their rating capabilities. The company stated the data fields essential for running
the model were established when the model was first introduced in 2002. Since
then, the mortgage market has evolved considerably, with the introduction of
many new products and an expansion of risks associated with them. The report
went on to point out that requests for data are broken into three categories:
Primary a primary field for running their proprietary

mortgage rating system Moodys mortgage Metrics
Highly desirable used to supplement their understanding
of a borrowers risk profile
Desirable further help in risk assessment of a loan
The report implied that their current proprietary model for rating mortgage risk
does not currently incorporate the primary information they are now requesting
nor do they have the ability to assess the requested highly desirable or
desirable data to support their analysis. We again find reason to ask why
agencies are not expected to seek out more information than provided to them by
issuers or to verify even the non-financial data provided them by issuers.
Even in the existing data fields that the agency has used since 2002 as
primary inputs into their models they do not include important loan
information such as a borrowers debt-to-income (DTI), appraisal type and which
lender originated the loan.
Although the importance of DTI has been relatively less important in a
period of strong home price appreciation (HPA) it becomes of more importance
in a flat to declining HPA as borrowers have less access to appreciated equity
cushion in support of their ability to service a loan. The fact that this information
has not been a primary input to their model is even more surprising considering
78. Guidelines on External Credit, supra note 64, at 92 (Competent authorities

should not undertake a detailed assessment of the exact methodology used by the ECAI,
but should instead satisfy themselves that the credit assessment drivers used in the
ECAI's methodology are sensible predictors of creditworthiness, and that the ECAI's
internal procedures ensure that its pre-defined credit assessment methodology is applied
consistently in the formulation of all credit assessments within each broad asset class or
market segment.).
79. FitchRatings, Credit Policy Special Report 2007 Global Structured Finance
Outlook: Economic and Sector-by-Sector Analysis December 11 2006 at 37
80. Moodys Revised US Mortgage Loan-by-Loan Data Fields, Apr. 3, 2007.
that traditionally the loan to value (LTV) and FICO score and the borrowers DTI
are the three most significant measures of credit risk on a mortgage.81
Similarly, given the mortgage industrys move to automated appraisals the
lack of consideration of appraisal type as a primary input is concerning. Nonfull
appraisal techniques, such as AVMs, rely on public data that is ordinarily several
months old. In rising markets, AVMs depend on housing price data that is
slightly lower than current market conditions. However, in declining markets, the
AVM may overestimate property values given current market.82 The importance
of who the lender was, as it relates to loan quality, has also become obviously
more important in the wake of recent institutional failures of subprime lenders
many of whom failed due to weak underwriting standards.
The following figure details some of the more significant items of loan detail
that they are only now requesting.
FIGURE 10: NEWLY REQUESTED DATA FIELDS

NEWLY REQUESTED DATA FIELDS
PRIMARY HIGHLY DESIRABLE DESIRABLE

Option Arm* Amount in Collection Cash out dollar amount
Borrower Qualiication Payment - Amortization Master Servicer
Borrower Qualification Payment - Interest Rate Primary Servicer
Dollar amount of largest consumer credit tradeline that is currently open
Total count of outstanding and open consumer credit tradelines
Up to 12 months of the borrower's monthly payment history on the subject loan from the date of origination
The interest rate of the loan at origination
ARM FIELDS
The specific indicator (i.e. index) which governs adjustments in the loan's interest rate
Month of First Reset
How often the rate on a loan resets to a new rate (in months)
OPTION ARM FIELDS
Annual Payment Cap
The fully-amortizing, fully-indexed monthly payment
The minimum payment option available to the borrower (in dollars)
The length of time during which a borrower has a minimum monthly payment option (in months)
The maximum percentage of the original balance up to which the loan can negatively amortize (i.e. typically 110%, 115%, 125%)
Whether the loan is an "option arm"
The various payment options available to the borrower once the loan reaches the mandatory recast period or the negative amortization limit
* "When evaluating second lien loans, these fields are highly desirable for
the underlying first lien loans associated with these second lien loans"
Source: Moodys Revised US Mortgage Loan-by-Loan Data Fields, Apr. 3, 2007.
Moodys adds generally, in absence of key information, assumptions are

utilized though it is unclear , at any given time, how conservative these
assumptions are. As example, on a March webcast and conference call titled
81. Nomura Fixed Income Research, RMBS Basics 21 (Mar. 21, 2006), available at
http://www.securitization.net/pdf/Nomura/MBSBasics_31Mar06.pdf.
82. See, e.g., Jenine Fitter, Manufactured Housing: Waiting for the Rebound, 6
FITCHRATINGS, May 2004, at 1, available at
http://www.aaro.net/pdf/Reading%20Room/FitchReport.pdf (Fitch is concerned that,
under certain weakening housing conditions, any valuation method other than a full
appraisal is likely to overestimate property value. As it relates to automated valuation
models (AVMs), Fitch believes that the risk of property overvaluation is particularly
great in declining markets. In Fitchs opinion, such risk is paramount when alternative
valuation methods are employed because of the time lag in the underlying data collection
process. Nonfull appraisal techniques, such as AVMs, rely on public data that is
ordinarily several months old. In rising markets, AVMs depend on housing price data that
is slightly lower than current market conditions. However, in declining markets, the
AVM may overestimate property values given current market conditions.).
Subprime Mortgage Distress Effect on CDOs,83 Fitch staff were asked about
the home price assumptions they are assuming. After several participants pressed
them on the issue a Fitch respondent stated that they assumed a mid-single digit
HPA. This is in stark contrast to fourth-quarter median home price data for 2005
and 2006 which confirms a national home price correction has been under way,
with the U.S. median home prices down 2.7%.84
Since mortgage backed securities primary risk exposures are to default and
prepayment risk, credit risk and market risk, many of the fields Moodys is
requesting have obvious and considerable importance in properly analyzing the
risks to RMBS and residential mortgage exposed CDOs. This would be
especially true in a period of weakening home prices, rising rates or declining
employment and income. Such evolutionary approaches to rating processes are
not rare.85
Part of the problem in the rating methods for ABS (including RMBS) and for
CDOs may well be that these methods, which are statistical, are built on other
rating models which are also statistical and the correlations between them may be
underappreciated in good times and rise suddenly in bad times.
Default correlations are higher during economic downturns or recessions and
it has been viewed that macro-economic factors are the main driver of portfolio
losses86 and at the portfolio level, dependencies between defaults are crucial and
little is known about them.87 As agency models are increasingly used to rate
assets such as RMBS and CDOs that themselves are more directly tied to
exogenous macro-economic conditions than by the endogenous conditions of a
particular enterprise, such as a corporate issuer, the importance of measurement
data to inform correlation modeling should be more significant in these assets.
Historic data is used by agencies in informing correlation assumptions and they
advocate the use of empirical default correlation to benchmark internal
models.88
83. Fitch Webcast: Subprime Mortgage Distress Effect on CDOs Tomorrow 09:30
am HK/SG Standard Time (Apr. 22, 2007), available at
http://www.derivativefitch.com/press_release_frame.cfm?pr_id=353234.
84. Fitch Reports on How the Housing and Mortgage Market Downturn Could
Affect Municipal Credit, BUSINESS WIRE, Apr. 25, 2007, available at
http://home.businesswire.com/portal/site/google/index.jsp?ndmViewId=news_view&new
sId=20070425006074&newsLang=en.
85. Jody Shenn, BLOOMBERG, Apr. 4, 2007, available at
http://www.elitetrader.com/vb/showthread.php?threadid=91393. (On April 4, 2007
Bloomberg reported Moodys (is) concerned that the growth of synthetics, or credit
swaps, may leave more CDOs invested in other CDOs exposed to the same bonds as they
are. The company said its models were developed using the data that was available at the
time, such as transactions backed by cash collateral. Moodys is now working on a
research project to reassess the correlation between CDOs at time when exposures can be
infinitely replicated, it said. Moodys sees increasing correlations in performance,
which suggests it will require more protection for bondholders when the project is
finished. Well update the market with our final findings when were done, Fu said.).
86. Arnaud de Servigny & Olivier Renault, Default Correlation: Empirical
Evidence, STANDARD & POORS, Nov. 23, 2002, at 12, available at http://www.risklab-
madrid.uam.es/es/jornadas/2002/CorrelationPresentation.pdf.
87. Id. at 3.
88. Id. at 28.
Given that there is little empirical data on many of these newer assets to be
rated, such as non-traditional mortgage assets, should we to expect that their
correlation assumptions within these newer assets will be subject to increased
volatility as down-cycle empirical data is being captured or should we assume
that the statistical assumptions they use will themselves be conservative enough
in their adjustments to compensate for the scarcity of full-cycle data?
As example, one of the key considerations in RMBS ratings is the servicer
rating of the firm(s) servicing the pool. When home prices are rising,
employment is strong, and interest rates are benign, mortgage performance tends
to be strong. Such an environment leads to low servicing costs, the management
of servicers being less strained, capital requirements and liquidity risks of
servicers being low, and the sophistication and operational efficiencies of
servicers being less important. As a result servicers ratings are less subject to the
rigors of market stress testing since almost everyone appears to be doing a decent
job of servicing.
As problems emerge for mortgage performance, such as reduced home price
appreciation or rising interest rates or declining incomes or employment, market
liquidity becomes more scarce as investors become increasingly risk averse. Just
as the relation of this effect is positively correlated to servicing performance on
the upside it is positively correlated to servicing on the downside. This places the
value of using servicer ratings as a forecasting tool in RMBS performance at risk
since, at the time mortgage performance declines the cost to servicers of
servicing problem loans rise as do the demands on their operational platforms
efficiency and management. So, as liquidity may be moving away the mortgage
space it will also be moving away from the servicer market at precisely the time
it is most dear.
In an environment of stabilizing home prices or a slowly increasing rate
environment, assuming other aspects of the mortgage process were effective
(underwriting quality as example), the agencies models might not be subject to
stress. In an environment where market liquidity reverses quickly both RMBS
and servicer rating models would be subject to significant and perhaps
unanticipated stress that the agencies only catch after the effect is generally seen.
This raises further question about the predictive value of their models in
structured finance.
In a real world example, on October 30, 2006 Fitch announced that it upped
the residential primary servicer rating of New Century from RPS3+ from RPS3
(the ratings are based on a scale of 1-5 with 1 being highest). At that time the
Companys servicing operation was commended for its competent management
team, established servicing platform, capable default technology, and enhanced
cross-functional training platforms.89
At that time, although the environment in which New Century was more
challenging that in recent prior years, New Century appeared to be managing
well. The Company, which operated three businesses; portfolio, mortgage loan
operations and servicing stated their average workforce increased from 5,594
for the nine months ended September 30, 2005 to 7,119 for the nine months
ended September 30, 2006, an increase of 27.3 percent. This increase in
89. See New Century Servicing Improves Fitch Bumps Subprime Servicer
Rating, MORTGAGE DAILY, Oct. 30, 2006, available at
http://www.mortgagedaily.com/NewCenturyRating103006.asp.
workforce was mainly due to our acquisition of the mortgage loan origination
platform of RBC Mortgage in September 2005. The remainder of the increase
was primarily due to growth in our servicing platform and the mortgage loan
portfolio90. In the same filing the Company stated its Servicing income
increased 100.8 percent to $47.4 million for the nine months ended
September 30, 2006, compared to $23.6 million for the same period in 2005.
Unfortunately, instead of filing a timely Annual Report for 2006, on March 3,
2007 the Company announced a late filing91 and warned it will restate its
consolidated financial results for the quarters ended March 31, June 30 and
September 30, 2006 and that it expected to ultimately report a pre-tax loss for
both the fourth quarter and full-year of 2006.
While the rating agencies could not be expected to have known of the
corporate accounting issues of New Century and the Company, in its statement,
indicated that other business lines than the servicing business were primarily
responsible for the losses, the liquidity problems that ensued ultimately could
have impaired the Companys servicing of loans. As a result, on March 5,
Moodys downgraded New Centurys servicer rating from SQ3+ to SQ4.92 On
March 7, Fitch lowered the ratings to RPS4 from RPS3+.93 Shortly after, New
Century defaulted on repurchase obligations. This resulted, in part, from
downgrades of their servicer ratings.94 On April 6, Moodys downgraded the
servicer rating of New Century to SQ4- from SQ4.95
So, in building models, the agencies might build a servicer rating based on
the performance of a servicer whose business may become at risk based on
businesses other than servicing. Moreover, as the mortgage market becomes
more volatile and difficult for lenders whose loans may be those serviced by the
same company, the risks are compounded. To then use the servicer rating as part
of the rating process for a mortgage-backed security can have the mathematically
equivalent impact of double counting. Obviously, the rating agencies role itself
can define the difference between life and death.
Just as one of the key considerations in the evaluation of RMBS assets is the
servicing entity, an important pillar of Fitchs rating process for a CDO is an
90. New Century Financial Corp., Quarterly Report (Form 10-Q), at 62 (Sept. 30,
2006), available at http://www.sec.gov/Archives/edgar/data/1287286/
000089256906001359/a24944e10vq.htm#103.
91. New Century Financial Corp., Notification of Late Filing (Form 12b-25),
available at http://www.sec.gov/Archives/edgar/data/1287286/
000119312507045551/dnt10k.htm.
92. New Century Ratings Downgraded Moody's lowers servicer rating to SQ4,
MORTGAGE DAILY, available at
93. See New Century's Survival in Doubt Fitch lowers servicer rating,
MORTGAGE DAILY, Mar. 7, 2007, available at
94. New Century Crumbling Defaults disclosed in SEC filing, MORTGAGE DAILY,
available at http://www.mortgagedaily.com/NewCenturyCreditors031207.asp.
95. Coco Salazar, Mergers Dissolve: Latest Mortgage M&As Corp activity,
MORTGAGE DAILY, Apr. 6, 2007, available at
http://www.mortgagedaily.com/Mergers040607.asp.
assessment of the capabilities of the originator, servicer or portfolio manager

(manager) to service or manage the CDO.96
Fitch places significant weight on the quality of individuals involved in the
management of CDO portfolios. Key-person risk represents one of the explicit
scores within the staffing category of Fitchs CDO asset manager ratings
scorecard. Among the factors incorporated into the evaluation of key-person risk
are: the depth of overall management and staff, key-person participation in CDO
debt and/or equity, and the relative challenge for the organization in acquiring
qualified replacement personnel. Variables that may affect this challenge include
location, as well as reputation and market position of the firm.97 While these are
each logically and sensible items to consider of importance in assessing the rating
of a CDO we are again confronted with the reality that the new ratings methods
of a novel asset are informed by the new ratings methods of a novel component
(in this case CAM) and there is little empirical history to support either of these
scales.
No one would argue that reputation, as example, is a critical indicator in
judging a person or institution, reputational risk arises quickly as demonstrated
over the past decade by the fall of former stars including Long Term Capital,
Enron, Amaranth. More recently we have seen over 60 U.S. mortgage lenders
disappear between late 2006 and late April 2007. For shorter lived assets, and
over shorter periods ratings adjust more slowly than market-prices98 so why, if
rating agencies do not observe such deterioration before they are observable in
markets, and re-rate existing assets only infrequently, should investors be bound
to their process?
With limited historic data, relatively no significant cyclical macro-economic
experience and a large backlog of not yet profiled CDO managers99 a fuller
understanding of their assessments appears critical.
E. Regulatory Issues
Given the rapid growth in issuance shown in the table above it would seem
appropriate to consider whether the rating agencies have been appropriately
spending on operational risk issues including systems and staff, relative to the
growth in rated assets.100
96. Global Rating Criteria for Collateralised Debt Obligations, FITCHRATINGS,

Sept. 13, 2004, at 19, available at
http://pages.stern.nyu.edu/~igiddy/ABS/fitchcdorating.pdf.
97. FitchRatings CDOpinions, Apr. 19, 2005, at 3
98. Richard Sylla, Historical Primer on the Business of Credit Ratings, 14 (New
York University, Stern School of Business Working Paper), available at
http://www1.worldbank.org/finance/assets/images/Historical_Primer.pdf.
99. Walden Siew, Subprime turmoil may take toll on CDO managers, REUTERS,
Feb. 28, 2007, available at
http://www.reuters.com/article/reutersEdge/idUSN2215228920070228. see e.g Fitch
Rating, for example, has profiled 66 CDO managers, about a third of which have some
exposure to subprime debt and a backlog of about 60 new managers still need to be
profiled
CESR/06-545 at 70 (EFFAS points out that the key factors to achieve a high standard
Just as bank regulators are tasked with examining regulated institutions and
look at such issues as capital, assets, management, earnings, liquidity and
sensitivity to market risk, the SEC staff review aspects of the rating agencies
business and seem to have some ability to, among other powers, make sure that
the agencies are staffed with an appropriate number of experienced ratings staff
and operate independently of the companies they rate.101 The SEC examines the
rating agencies every five years102 and their authorities, in approval of new and
continuing registration of NRSROs, are defined by law.
Last year, Congress passed the Credit Rating Agency Reform Act of
2006103 which, among other things authorized the SEC to suspend or revoke the
NRSRO status of a current registrant if it didnt have the financial or managerial
resources to produce ratings with integrity.104 In a letter to SEC Secretary Katz in
June of 2005, S&Ps President Kathleen Corbet in answer to the SECs question:
The Commission requests comment on the appropriate subjective criteria that a
credit rating agency should use in assessing the experience and training of an
analyst to meet the proposed NRSRO definition? responded that While Ratings
Services is confident that its standards and procedures for analyst background
and training would meet any minimum requirements imposed by the
Commission, Ratings Services does not support the promulgation of NRSRO
designation criteria that are conditioned on specific attributes of a rating agencys
staff.105
of credit rating are human resources and the skills of the staff employed. The professional
background and qualification of the CRAs employees is not published and there is not a
framework of statutory rules requiring a specific professional standard of training. So it
concludes that it is difficult to assess whether the resources employed by the CRAs are
sufficient.
Similarly, Rating Evidence stresses that only a very few analysts undergo training to
absorb the CRAs rating philosophies and approaches at one of the universities offering
rating education. Thus usually the analysts receive only on-the-job and in-house training.
This respondent concurs that the confidence in the ratings would increase if rating
analysts education would be more structured like in other professions.).
101. See, e.g. Credit Rating Agency Reform Act of 2006, S. 3850, 109th Cong.
2(E) (2006), available at http://frwebgate.access.gpo.gov/cgi-
bin/getdoc.cgi?dbname=109_cong_bills&docid=f:s3850enr.txt.pdf.
102. See Lancellotta Statement, supra note 56.
103. Credit Rating Agency Reform Act, supra note 101.
104. Id. (The Commission shall grant registration (to applicants for NRSRO
status) under this subsection (i) if the Commission finds that the requirements of this
section are satisfied; and (ii) unless the Commission finds (in which case the Commission
shall deny such registration) that (I) the applicant does not have adequate financial and
managerial resources to consistently produce credit ratings with integrity and to
materially comply with the procedures and methodologies disclosed under paragraph
(1)(B) and with sub-sections (g), (h), (i), and (j); or (II) if the applicant were so
registered, its registration would be subject to suspension or revocation under subsection
(d).).
105. Letter from Kathleen A. Corbet, President, Standard & Poors, to Jonathan G.
Katz, Secretary, United States Securities and Exchange Commission 8 (June 9, 2005),
available at http://www.sec.gov/rules/proposed/s70405/standardpoors060905.pdf.
While little publicly available information is available about the specific

number of analysts the rating agencies employ106 to rate particular asset classes
there is reason to wonder if the rating staff would have the necessary capacity to
review and update their ratings if there were a significant increase in asset
volatility, deterioration the in macro-economic environment or liquidity event. It
has been suggested that ratings frequency also poses problems in the CDO
market. Sources say that rating agencies usually only surveil the bonds once a
year.107
In testimony to the Senate Banking Committee in February of 2005, Fitchs
President and CEO stated that Fitch has approximately 1,600 employees,
including over 750 analysts, in over 49 offices and affiliates worldwide. Fitch
currently covers over 4,400 corporations, banks and financial institutions,
sovereigns and 40,000 municipal offerings in the United States. In addition, we
cover over 7,500 issues in structured finance, which remains our traditional
strength.108 In the same hearings Moodys President, Raymond McDaniel stated
we have more than 1,000 analysts in 18 countries around the worldOur
ratings and analysis track more than $30 trillion of debt issued in domestic and
international markets, covering approximately 10,000 corporations and financial
institutions, more than 20,000 municipal debt issuers, over 12,000 structured
finance transactions, and 100 sovereign issuers.109
Given the increasing rating agencies play in supporting bank capital
requirements and as they have expanded internationally, IOSCO, the
International Organization of Securities Commissions has become increasingly
active in assessing the role of credit rating agencies. In December of 2004
IOSCO released code of conduct for the rating agencies110 to which the SEC has
explicitly noted its support in the current rulemaking process.111 The December,
2006 report by the Committee of European Securities Regulators regarding the
compliance of CRAs with the code was part of the monitoring process in
response to questions raised whether voluntary compliance with the code was
106. Id. at 7. (Ratings Services believes that the Commission could appropriately
consider the number of analysts employed by a credit rating agency in the NRSRO
designation process. However, mandating disclosure by rating agencies of the average
number of issues rated by those analysts would serve little practical purpose and might in
fact mislead the market.).
107. Structured Finance Roles, FIN. ENGINEERING NEWS (2005), available at
http://www.fenews.com/fen43/euro_angles/euro_angles.html.
108. Before the S. Comm on Banking, Housing, and Urban Affairs, 109th Cong. 1-
2 (2005) (statement of Stephen W. Joynt, President and Chief Executive Officer of Fitch
Ratings), available at http://banking.senate.gov/_files/joynt.pdf.
109. Before the S. Comm on Banking, Housing, and Urban Affairs, 109th Cong. 1-
2 (2005) (statement of Raymond W. McDaniel, President, Moodys Investors Service),
available at http://banking.senate.gov/_files/mcdaniel.pdf.
110. Press Release, International Organization of Securities Commissions, Iosco
Releases Code Of Conduct Fundamentals For Credit Rating Agencies (Dec. 23, 2004)
available at http://www.fsa.go.jp/inter/ios/f-20041224-3/02.pdf.
111. See Securities and Exchange Commission Release34-55231 File No. S7-04-07
Oversight of Credit Rating Agencies Registered as Nationally Recognized Statistical
Rating Organizations p.10 SECURITIES AND EXCHANGE COMMISSION 17
CFR Parts 240 and 249b [Release No. 34-55231; File No. S7-04-07] RIN 3235-AJ78.
appropriate and effective or if regulators would need to be more proscriptive.112 It

was recently reported that European officials would report to the annual meeting
of IOSCO that more monitoring of ratings is needed and that structured products
such as collateralised debt obligations and collateralised loan obligations are
unusually opaque products and investors cannot see through to the credit quality
of the underlying borrowers making interest and principal repayments on those
securities. They [Officials] are also concerned about potential conflicts of interest
developing among rating agencies whose staff work closely with banks that issue
CDOs and CLOs to design securities that are eligible for particular credit ratings.
Because of the opacity and complexity of these debt instruments, investors such
as pension schemes are more dependent on guidance from rating agencies113
The suggestion that officials are not only concerned about actual conflicts of
interest but the appearance of conflicts that might undermine investor
confidence?
F. Rating Agencies Are Activist in Ways They Have Never Been
Over the past several years we have witnessed a seemingly significant public
role of the agencies as described by the de-facto designation they have received
as gatekeepers of bank capital adequacy.
There are examples over the past few years that, given their increased
importance to global capital flows, are worth public policy consideration.
Whether or not these activities are a result of real or perceived conflicts of
interests on behalf of issuing clients is unclear. What is clear is that NRSRO
powers have extended to areas of public policy in ways we have not witnessed
before.
In early 2004, after accounting problems were discovered at Freddie Mac but
before those of Fannie Mae were fully uncovered, Congress again embarked on a
legislative process to create a new regulator with enhanced powers. One of the
key provisions legislators considered was one that would better define the
receivership authority of the GSEs regulator in case they became seriously
undercapitalized. In early April S&P hinted about a possible downgrade of GSE
debt if a new regulator had receivership powers.114 This announcement
supported the GSEs goals of trying to prevent receivership authority from being
included in legislation. It is unclear if this was done out of support for one of the

CESR/06-545 at 2 (On 30 March 2005, at the request of the European Commission,
CESR delivered its advice (CESR/05-139b) regarding the potential options to regulate
Credit Rating Agencies (CRAs). In its advice, CESR proposed not to regulate the Credit
Rating Agencies industry at an EU level for the time being, and instead proposed that a
pragmatic approach should be adopted to keep under review how CRAs would
implement the standards set out in the IOSCO Code of Conduct.)
113. Gillian Tett, Credit rating groups under microscope, AUSTRALIAN, Apr. 10,
2007, available at http://www.theaustralian.news.com.au/story/0,20867,21528953-
36375,00.html.
114. See, e.g., Dems prepare new GSE bill, GOP bill vote is today, CREDIT UNION
NATIONAL ASSOCIATION, Apr. 1, 2004, available at
http://www.cuna.org/newsnow/archive/list.php?date=033104.
rating agencys largest single clients or as a result of fundamental analysis. It was

later reported that the Chief Executive of the national Association of Home
Builders, a longtime political ally of the GSEs, visited Wall Street bond-rating
agencies Standard & Poor's, Moody's Investors Service, and Fitch Ratings,
Howard spread the word that Fannie's and Freddie's bonds might be downgraded
if the legislation passed. 115 After Fannies regulator released a long anticipated
investigation report there was a great amount of uncertainty about the Companys
financial condition as there had not yet been any agreement announced between
the regulator and the Company. During that three day period between the release
and an announcement of an agreement with the Regulator Fannie Maes stock
lost about 15 percent of its market capitalization. Remarkably, during this
uncertain time, Standard & Poors (S&P) issued a statement that affirmed Fannie
Maes AAA rating on its senior debt.116
In February of 2005, after the full extent of Fannies problems were better
understood the Senate banking Committee held hearings during which Senator
Sununu asked S&P President Kathleen Corbet Ms. Corbet, less than a year ago,
one of your analysts, Michael DeStefano, suggested that the GSE legislation we
were considering before this Committee would cause S&P to reconsider the
AAA rating it had for GSE unsecured debt. I read this account to mean that if we
included receivership provision in that bill, then you would basically downgrade
the credit rating of the GSEs. Ms. Corbet responded First of all, Senator, if I
may, let me start by saying that Standard & Poors does not advocate positions
on any legislation. Senator Sununu responded You say that it is not your
intention or your policy to have analysts comment on or lobby for or against
specific pieces of legislation. But do not you think weighing in with a perspective
on how this affects a de facto position on legislation? Senator Reed continued,
in his questioning I think a quote from a report by Mr. DeStefano and Ms.
Wagner would be, The slightest evidence that Congress would in any way agree
to lessen its authority or cede it to others would in itself necessitate a rethinking
of how much confidence bondholders should have that their interests would be
taken into consideration in the case of a failed GSE. And I think your response
was you do not comment on legislation, but can you comment on that quote?117
This was not the first time that the rating agencies have become involved
with legislation in a seemingly direct way. While the authors can find no high
profile examples, prior to this decade, in which rating agencies had the effect of
potentially impacting legislation, this was the second such even in a very short
period. The prior case was not at the national level but rather at the states level.
While the motivation for their actions is unclear, it is interesting to note that in
both examples, at least one agencys position was aligned with their customers
financial interests and their own.
115. Bara Vaida, Taking Cover, NATL J., May 28, 2005, available at
http://w4.stern.nyu.edu/news/news.cfm?doc_id=4544.
116. Robert A. Eisenbeis, W. Scott Frame & Larry D. Wall, Resolving Large
Financial Intermediaries: Banks Versus Housing Enterprises (Federal Reserve Bank of
Atlanta, Working Paper Series, Paper No. 2004-23a, 2004), available at
http://www.frbatlanta.org/filelegacydocs/wp0423a.pdf.
117. Examining the Role of Credit Rating Agencies in Capital Markets: Hearing
Before the S. Comm. on Banking, Housing, and Urban Affairs, 109th Cong. 21 (2005),
available at http://a257.g.akamaitech.net/7/257/2422/19jul20061200/
www.access.gpo.gov/congress/senate/pdf/109hrg/28059.pdf.
On October 1, 2002, the Georgia Legislature passed sweeping new anti-

predatory lending legislation. The Georgia Fair Lending Act118 contained a
provision that assigned unlimited liability exposures to lenders who made high
cost loans (and noteholders). In January of 2003 the three major credit-rating
agencies announced that they would no longer be willing to rate RMBS
originated in Georgia119 As a result, the Georgia legislature moved quickly to
make amendments to their legislation to stop lenders from leaving the State. As
other States began to move to pass similar legislation they were reminded of the
effect that the Georgia law had and also limited their liability provisions.
G. Other Legal Risk Securitization Law
As we discussed previously in this paper, recent problems in the subprime

mortgage finance market and housing industry are likely to give rise to litigation
against various involved parties. Those suits are likely to be brought on behalf of
homeowners, private investors and, potentially qualified institutional buyers of
structured financial assets.
Given the brief history of securitization markets it would seem important for
investors to fully consider risks to structures and the potential risks that
conflicting interests could bring to bear. In practical terms securitization is the
process by which an institution transfers its assets to a legally isolated and
bankruptcy remote special purpose entity (SPE or SPV).
The assets, structured properly, are allowed to be removed from the balance
sheet of the selling company it then records a gain in accordance with accounting
standards. To be effective for the selling company the sale must comply with
domestic and international accounting standards. Auditors will not sign off on
moving of assets off of the balance sheet for accounting purposes without a
legal opinion recognizing the securitization as a true sale. That is to say,
simply, that the assets have moved beyond the control of the seller.
This serves several purposes, especially for financial institutions. Among
them, it generally allows the firm to have less deposits to fund loan activity, in
most periods this market financing will be less costly to larger institutions than
other funding, and it generally allows them to hold less regulatory capital than
they would have to if they held all of the credit risk.
The position of the agencies, in the case of the Georgia legislation further
highlights the potentially inconsistent approaches they use in the rating process.
While the agencies took a strong stance on their inability to rate assets whose
legal isolation was in question in that case they appear not to have widely
highlighted the risk to investors as a result of LTV Steel or NextBank.
In December 2000, LTV Steel filed for voluntary Bankruptcy protection
under Chapter 11 in the US Bankruptcy Court of Northern Ohio120. In their filing
the Company asked the court to grant an emergency motion to allow them to use
the collections from the securitizations and claimed that the transactions were not
true sales but rather disguised financings. The Court granted the Companys
118. Georgia Fair Lending Act, GA Code. Ann. 7-6A-1 et seq.

119. Susan Romero, Georgia lending law now toothless, INMAN NEWS, Feb. 28,
2003.
120. See, e.g., In re LTV Steel Co., 274 B.R. 278 (Banker. N.D. Ohio 2002)
motion though it did not rule whether or not the securitizations were true sales.
Although this case could have caused the rating agencies to take the same
position as the Georgia law, of ambiguity making it difficult to rate the risks to
noteholders they chose not to. In fact, one of the agencies appeared to pressure
attorneys to avoid commenting on the matter in legal opinions. Standard &
Poor's insisted that attorneys submitting true-sale opinions to the rating agency
stop referring to LTV, noting that the court never made a final decision and that
such citations inappropriately cast doubt on the opinion. Seven months later, in a
delicately worded press release, S&P withdrew that prohibition--apparently
because lawyers refused to ignore such an obvious legal land mine.121
Rating agency claims of their inability to assess the limits of credit risk
exposures to investors in Georgia as a result of the 2002 legislation becomes
more interesting to note given their relative silence in addressing potential
ongoing risks to investors that could be posed by the explicit authority of the
FDIC, after meeting certain thresholds, to abrogate contracts as receiver of a
failing institution.122 In the case of NextBank the FDIC abrogated an accelerated
payment contract provision for noteholders of a credit card securitization. Unlike
the LTV Steel case, there was a clear determination in Bank of New York v.
FDIC. Although the FDIC did not seek to invalidate or question the legal
isolation of the securitization trust it did, nonetheless, abrogate certain payments
to noteholders. It is therefore not only unclear how far the FDICs authority
would extend into a securitization trust but it is unclear if this is considered in
rating assessments.
Corporate bond values are not dependent upon recourse, servicing incentives,
and other external factors. That is because even if the bonds are collateralized by
specific assets, the corporation is explicitly tied to those assets and services and
otherwise maintains their profitability within the corporate structure. If the
collateral backing the corporate bonds experience difficulty generating cash
flows sufficient to pay creditors, the corporation can channel excess revenues
from other operations to cover the shortfall. Those differences, described below,
create the basis for important fundamental differences in rating corporate bonds
and RMBS or ABS.
III. TRADITIONAL BOND RATINGS DO NOT PROPERLY ACCOUNT FOR

RESIDENTIAL MORTGAGE-BACKED SECURITY RISKS
While the type of discretionary decision-making described above can be

fairly benign for typical corporate debt ratings, it has dire consequences for
RMBS and CDO ratings. Ratings are intended to reflect risk to investors, and are
of utmost importance in markets where financial instruments are highly
differentiated and market price signals are lacking.
While arguments for proper ratings paradigms are often derailed by the
minutiae of complex RMBS and CDO securities, we maintain that sufficient
121. Tim Reason, False security? Corporate insolvencies are testing whether
securitization is a stable structure or a flimsy faade- Bankruptcy 2003, CFO: MAGAZINE
FOR SENIOR FINANCIAL EXECUTIVES, June 2003.
122. The Bank of New York v. Federal Deposit Insurance Company, 453
F.Supp.2d 82 (D.D.C. 2006), available at https://ecf.dcd.uscourts.gov/cgi-
bin/show_public_doc?2003cv1221-75.
prima facie evidence to argue that traditional ratings practices create dire
consequences when applied to RMBS and CDOs (and other structured finance
securities) in fundamental structural differences between the different firms
involved, i.e., the RMBS pool trust versus the corporation. We demonstrate
below that merely creating a pool of investments does not build diversification.
Then we show that the static nature of the firm in structured finance makes the
securities of that firm much more volatile than equivalently-rated corporate
securities. When those static firms invest solely in fixed-income investments
that is no reason to delay downgrades as there is no way for the static firm
investments to recover and no way to redeploy capital. Since there is also no way
for the firm to siphon off excess earnings, however, there is also no reason to
delay upgrades.
Hence, RMBS, as part of a static capital structure, funding a static investment
strategy composed exclusively of fixed income assets, and trading thinly over-
the-counter with few market price signals, require dynamic ratings in order to
adequately reflect risk. The main point is therefore that, in the case of RMBS,
bond ratings are being used for something they were not initially intended and
often sold on the basis of a fundamental misunderstanding of diversification.
Below we show the implications of these fundamental shortcomings. Section
III.A focuses on how the principal of diversification has been misrepresented by
Wall Street. Section III.B analyzes the implications of rating RMBS with
corporate debt rating techniques. Section III.C provides several case examples to
illustrate common performance characteristics of ABS and RMBS.
A. Pooling Mortgages does not create Diversification
One of the primary myths perpetuated on Wall Street is that mortgage pools
are diversified. Commonly cited claims read like the Wall Street Journal editorial
on April 25, 2007, in which Ted Frank wrote that, diversification [in
mortgage pools] reduces the risk of lending to borrowers with suboptimal credit.
Such claims represent a fundamental misunderstanding of the distinction between
risk pooling, risk sharing, and diversification.
Risk pooling is the mere act of adding another investment to build up a
portfolio. Suppose we have one $100,000 mortgage with a 2 percent probability
of complete loss (the borrower never pays and an earthquake sucks up the house
and land). Expected payout on the loan is $98,000 and standard deviation (risk)
of the investment is 14 percent. It seems like we can lower the standard deviation
of the outcome by accumulating a pool of mortgages. By accumulating, say,
10,000 identical uncorrelated mortgages the standard deviation of the pool indeed
declines to 14%/10,000 = 0.14%.
The problem is that we have decreased the percent of portfolio risk (standard
deviation) but increased the dollar amount of the portfolio. Basic MBA-level
finance, however, teaches that if we wish to compare the risk of two investments
of different scale, we must compare the dollar profits from the two. When we
combine a number of uncorrelated investments both expected profit and standard
deviation grow in direct proportion to the number of investments. Since the
risk/return tradeoff does not improve with the accumulation of more mortgages,
there is no diversification in pooling mortgages.123
The advantage of pooling investments lies in the ability to more efficiently
share risk with other investors. After the pool is constructed, the risk of the
mortgage pool can be distributed by allowing investors to share the risk through
purchasing securities representing a partial claim on the pool. Those investors,
each with a fixed-size portfolio to allocate across investments, can now allocate
risk across more sources of risk, helping them diversify their own portfolios.
According to Bodie, Kane, and Marcus, portfolio risk management is about the
allocation of a fixed investment budget to assets that are not perfectly correlated.
In this environment, rate of return statistics, that is expected returns, variances,
and covariances are sufficient to optimize the investment portfolio. Choices
among alternative investments of a different magnitude require that we abandon
rates of return in favor of dollar profits.124
B. Current Bond Ratings Methods are Misleading when Applied to RMBS
This section examines the fundamental differences between debt originated

by corporations and debt originated by mortgage pool trustee (RMBS). Both the
corporation and the pool trustee fund a pool of investments with a structure of
securities. Differences between the two, which arise primarily from differences in
static versus dynamic capital structures, static versus dynamic investment pools,
and investment in real versus fixed-income assets, are illustrated in Figure 10.1.
FIGURE 10.1: FIXED AND STATIC FIRMS ILLUSTRATED

Corporate Structure RMBS Structure
Corporate entities invest in pools of real investment projects that can

substantially outperform or underperform expectations. As a result, investment
returns can be evenly distributed above and below expectations. Corporate
entities can dynamically manage their investment strategy. If an investment
project underperforms the corporation can sell that project and invest the
proceeds in another, completely different, project. Corporations can also
dynamically manage their capital structures. If risk is expected to increase in the
future, the corporation can accumulate additional equity by selling stock or
saving current period excess earnings (retaining earnings) from real investment
projects to buffer creditors from that increased risk.
123. See ZVI BODIE, ALEX KANE & ALAN J. MARCUS, INVESTMENTS 232-233 (7th
ed., McGraw Hill/Irwin 2007).
124. Id. at 234.
In contrast, the assets in the mortgage pool are a pre-specified pool of fixed-
income investments. While fixed-income investments may outperform
expectations, that only means they pay in full as originally contracted. The upside
potential is therefore the expected loss rate, which has historically been just over
0.15 percent in the mortgage sector.125 Since the mortgage pool must be brain-
dead in order to avoid being classified as an investment company (and therefore
taxed) the assets are pre-specified. The pool trustee therefore has no authority to
change the pool investment strategy in reaction to unexpected underperformance.
Since the pool trust is brain-dead, the pool trustee also has no authority to change
the capital structure by selling new equity to buffer creditors from the increased
risk. The pools ability to accumulate additional equity by saving current period
excess earnings is inherently limited by the minimal upside potential on the
fixed-income assets.
These simple distinctions create several important differences between
corporate debt and mortgage pool debt (RMBS) with respect to 1) the
fundamental source of default risk; 2) the meaning and relevance of performance
point estimates; 3) the dynamics of cumulative losses; 4) the shape of statistical
distributions on conditional losses; 5) the width (standard error) of those
statistical distributions; and ultimately 6) the nature of decision-making in
upgrade and downgrade decisions and 7) the use and relevance of credit
enhancement.
1. Corporate Default Risk is a Function of Investment Decisions, while

RMBS Default Risk is a Function of Investment Performance
The dynamic nature of corporate investment decisions creates benefits and

risks for corporate debt that are not relevant to RMBS.
The main risk with dynamically managed investment strategies is that
investors are at the mercy of managements future investment decisions. If
management changes the investment strategy the composition of the
dynamically-managed pool of assets may change adversely and/or unexpectedly
over life of investment.
The primary risk of corporate debt is therefore the classic free cash flow
problem of standard corporate finance. Corporate finance teaches us that a
number of mechanisms discipline free cash flow. Company seasoning,
management longevity and reputation, as well as monitoring by financial
institutions, provides assurance to investors. Hence, all of those factors are part
of the background due diligence that feeds into the bond rating process.
Of course, substantial benefits arise from a dynamic investment strategy. The
most basic benefit is that the ongoing series of individual corporate investments
creates a stable portfolio of investment projects in the same way that dollar cost
averaging does for individual investors creating stable returns from vintage
diversification.
In contrast to corporate debt, the benefit of a static mortgage pool investment
strategy is that there is no free cash flow problem because the brain-dead trust
125. The 1-4 family first-lien home mortgage chargeoff rate at all commercial
banks averaged 0.168% across the 1992-2006 period and never exceeded 0.348%
annually. See Statistics on Banking, available at www.fdic.gov.
cannot redirect the investments (although the servicer can alter the servicing
platform ex post, which is precisely the point of the structural changes outlined in
our earlier paper).
There is a substantial risk however, that the static mortgage pool investments
will be imperceptibly fundamentally flawed ex ante, since changes to origination
standards may be manifested in adverse loan performance only after a substantial
lag. Of course, such a movement precludes future securitizations from that
originator due to the reputational cost, but the originator also will not have to
provide costly ex post support to preserve market access. As the saying goes, the
only securitization without recourse is the last. Furthermore, static mortgage
pools offer no opportunity for vintage diversification, save through master trust
structures, which are cost effective only for the largest issuers. Even in a master
trust, however, vintage diversification can only occur within the mortgage sector:
the mortgage pool cannot accumulate non-mortgage investments.
In summary, an investment in corporate debt is an investment in a proven
ongoing dynamic investment strategy. An investment in a mortgage pool is an
investment in a static pool of unproven fixed-income investments. We explain
below how those differences make rating corporate debt very different from
rating RMBS.
2. Performance Point Estimates that are the Basis for Corporate Bond
Ratings are not Relevant for RMBS
Bond ratings are based on a point estimate of expected losses. If expected

losses breach a threshold of the firms ability to repay, the debt rating is
downgraded.
Expected loss point estimates are easy to compute for corporate bonds
because the investment strategies of most corporations are well-established and
management has credibly committed to continue investing in similar quality
assets in the future. Free cash flow problems have generally been resolved and
corporate governance problems contained. Investors generally know the asset
quality from prior firm performance and are able to use managements reputation
to extrapolate the firms investment strategy into future.
The above characteristics align with the view of an investment in a
corporation as a stake in a dynamic investment strategy. The expected loss
estimate on a consistent investment strategy is constant across time. A constant
expected loss rate is relatively easy to estimate and implement. If expected losses
are expected to breach a threshold of the firms ability to repay and the
corporation is not willing to change the strategy, the debt rating is downgraded.
FIGURE 11: EXPECTED LOSSES IN CORPORATE AND

STRUCTURED FINANCE DEBT
Cumulative Loss Level
Corporate Investments
% Loss on Asset Pool
Mortgage Pool
Time: zero to maturity
Source: R&R Consulting (2004).
Expected loss point estimates are more difficult to compute for mortgage
pools because mortgage pools are initially relatively unseasoned.126 Figure 11
illustrates the difference between loss estimates on corporate investments and
mortgage pools. The steep rise in losses in the left-most region of the expected
loss curve for the mortgage pool characterizes the ramp-up problem for
unseasoned investments.
A steep path of cumulative losses during the ramp-up period can indicate a
problem with the underlying collateral. The problem becomes, how do you
identify too steep? Uncertainty about the steepness of the ramp-up period has
therefore been the source of most previous private structured finance problems.
When pools have shown higher defaults during the ramp-up phase, the
mortgage pools have not be able to trap adequate excess spread to fund the credit
enhancement (which provides the primary backstop for default). This was a
typical problem with deals in the early 1990s, when several deals had to be
restructured in order to avoid complete failure.127
More recently, many mortgage pools exhibited similar early payment default
(EPD) problems where defaults rose faster than anticipated while the pool was
seasoning. On April 17, 2007, Wells Fargo announced that its revenue was
reduced by $90 million because of steps it took to address continued woes in the
subprime mortgage sector. The bank reduced the value of subprime loans in its
portfolio and set aside more funds for early payment default on loans that have
been securitized.128 After studying the collateral attributes of early payment
default (EPD) loans and comparing them to loans that did not default in the first
12 months after issuance, Fitch found that Fair Isaac Corp. (FICO) scores have
126. Seasoning requirements that stipulate mortgages be over 24 months old at

pooling are not especially relevant when a 2/12 ARM, for instance, goes into pool at that
time.
127. Note that all restructurings involving commercial banks required regulatory
approval, which in some cases was granted to avoid critical undercapitalization that
would have required regulatory discipline (see, for instance, Higgins and Mason 2005).
128. Ann Carrns, Some Prime Home Loans Seen Being In Trouble, WALL ST. J.
become less significant as an early default indicator when other high risk loan
attributes, such as piggyback second liens or loans with no-income verification,
are present.129 Such conclusions support our earlier assertions that fundamental
changes to origination and servicing standards over the past decade have led to
difficulties in valuing and pricing RMBS.
Given that problems predicting a moving expected loss rate early in the life
of a mortgage pool are the source of most RMBS problems, it appears that
predicting a moving expected loss rate on unseasoned collateral is much more
difficult than predicting a constant expected loss rate on an ongoing established
corporate investment strategy.
3. Cumulative Losses on Structured Finance Debt are Non-Decreasing
The point was made earlier that corporate obligations invest in real assets. As
a result, corporate investment portfolios can substantially outperform or
underperform expectations. Furthermore, corporate investment strategies can be
altered to take advantage of new investment opportunities, sometimes generating
returns that offset earlier losses.
Mortgage pools invest in fixed-income assets. Fixed-income assets cannot
substantially outperform expectations, but can significantly underperform
expectations. Furthermore, since the investment strategy and capital structure of
the mortgage pool is static, significant losses that accumulate in the pool cannot
be offset by either significant outperformance (that would generate excess
retained earnings) or changes to the investment strategy. The dynamics arising
from the different nature of the underlying collateral in corporate and mortgage
pool investments is illustrated in Figure 12. The solid s-shaped cumulative loss
profile (in gray) is that for a dynamic pool of real corporate investments, which
can recover from adverse shocks due to the real nature of the assets.
In contrast, because some corporate investments may be written off as losses
while others may perform substantially beyond expectations, corporate debt may
illustrate fluctuating cumulative loss dynamics.
Because mortgage pools are invested exclusively in fixed-income with little
potential for substantial outperformance, however, the pool has little or no
opportunity to recover from adverse loss rates. Static mortgage pools, because of
their ramp-up period and their limited upside potential, therefore illustrate rising
cumulative loss dynamics, with deviations lying primarily in the steepness of the
ramp-up curve.
129. Fitch Report Details Drivers of Early U.S. Subprime Defaults, BUSINESS
WIRE, Apr. 16, 2007.
FIGURE 12: ACTUAL AND EXPECTED LOSSES ON

CORPORATE INVESTMENTS AND MORTGAGE POOLS
Corporate Investments
Expected
Actual
Mortgage Pool
The rising cumulative loss profile (in black) is that for the mortgage pool,
which is a static pool of fixed-income investments. Note that the solid black line,
lying only slightly below the expected loss profile (the dashed black line),
represents the best possible outcome given previous losses, i.e., that in which the
remaining fixed-income investments in the pool pay out all remaining principal
and interest. The small amount of equity in the pool relative to the amount of
debt securities dictates that the best case line lie only a small distance below
the cumulative expected loss profile.130
While corporate investments have equal upside and downside performance
risk, mortgage pool investments have more downside risk than upside. That
means that the shape of the statistical distributions used to calculate expected
default probabilities, that is, bond ratings, is significantly skewed.
4. The Statistical Distribution of Mortgage Pool Performance Is Skewed

Relative to that of Corporate Investments
As pointed out above, a corporation can accumulate additional equity by

selling stock or saving current period excess earnings (retaining earnings) from
real investment projects to buffer creditors from that increased risk. Moodys-
KMV, in fact, uses that residual equity value to help estimate the probability of
default on corporate debt. KMV, as most models, treats the potential equity
returns as normally distributed, which suggests a statistical distribution of
expected losses facing corporate investments is similar to that represented in the
leftmost panel of Figure 13.
130. While some may be tempted to argue that the master trust structure (allowing
issuers other pools to co-insure one another) is meant to address that problem, it is still
the case, however, that pool cumulative loss profile will not recover. Other pools merely
contribute their own equity to subsidize non-performing pool.
FIGURE 13: STATISTICAL DISTRIBUTIONS OF CUMULATIVE LOSSES ON

CORPORATE INVESTMENTS AND MORTGAGE POOLS
Cumulative Corporate Investment Performance Cumulative Mortgage Pool Performance
Cumulative Loss Level Cumulative Loss Level

Time: zero to maturity Time: zero to maturity
The rightmost panel of Figure 13 illustrates further, however, that the skewed
mortgage pool loss distribution is centered around a moving point estimate,
whereas the (normal) corporate investment loss distribution is centered around a
constant point estimate. The ratings exercise for RMBS therefore becomes
estimating the area under an unknown distributional shape with a moving center.
But there is more.
The mortgage pools ability to accumulate additional equity by saving
current period excess earnings is inherently limited by the minimal upside
potential on the fixed-income assets. Furthermore, since the pool is brain-dead,
the pool trustee has no authority to change their capital structure by selling new
equity to buffer creditors from that increased risk. A mortgage pools investment
cash flows are therefore constant at best, and typically deteriorating to some
extent as losses accumulate (at a decreasing rate) through the life of the pool.
Residual equity is built up only from cash flows that accrue above
expectations, that is, unexpectedly low default or prepayment rates. With low
expected loss rates to begin with, upward performance potential is typically
limited to the two percent or so of equity typically included in RMBS structures.
Both corporate investments and mortgage pools, however, face equal
downside potential of total loss. Since there is limited upside potential to the
point estimate losses for the mortgage pool, the distribution of probable point
estimates in any time period is skewed rather than normally distributed. Figure
14 confirms the general shape of the skewed distribution from FitchIBCAs
Monte Carlo simulation of residential mortgage pool losses presented in their
technical literature.
FIGURE 14: SKEWED MORTGAGE POOL LOSS DISTRIBUTIONS
Source: FitchIBCA, ResiLogic: U.S. Residential Mortgage Loss Model Technical Document, Jan.
18, 2007 at 11.
5. Mortgage Pool Cumulative Loss Distributions Narrow over Time
The distribution of expected performance of corporate investments remains

constant for the life of the deal. That is, the width of the normal distribution of
expected losses remains constant around constant mean.
In contrast, the width of the skewed distribution of expected losses on
mortgage pool losses tightens around a moving mean. That is, the conditional
expectation of performance improves through the life of the deal. Seasoning, the
structure of the pool, and the erosion of uncertainty through time determine how
fast, and by how much, the credit quality changes. The rightmost panel of Figure
13 represents the concept by narrowing the skewed distribution as the investment
portfolio moves to the right, through time. The effect is sometimes referred to as
telescoping distributions.
Ratings agencies must therefore not only estimate the appropriate mean point
estimate at any given time in the mortgage pools life and the properties of the
skewed distribution of probable losses, but also the width of the skewed
distribution. Since all of these properties are variable, each is estimated with
statistical uncertainty. Furthermore, since the midpoint, the skewness, and the
width al change significantly soon after the deal goes on the market, ratings at
inception are less meaningful for RMBS and CDOs than for corporate debt.
Dynamic ratings are therefore necessary to properly assess secondary market risk
in RMBS and CDOs in lieu of market depth and transparency.
To summarize so far, we have shown that mortgage pool performance is
expected to change over time according to unknown processes and evolves with
skewed telescoping loss distributions. Those observations lead to important
implications for 1) upgrading and downgrading RMBS compared to corporate
debt, and 2) the value of credit enhancement on performing RMBS. Those
implications are analyzed in the next two sections.
6. Implications: When Mortgage Pools Do Not Perform, the RMBS Will

Not Be Promptly Downgraded by Traditional Ratings Methods
Because the performance of investments underlying corporate debt are

normally distributed and centered around a constant mean with a constant
variance, it is fine for corporate debt ratings to be determined by conventional
one-parameter loss estimates. Corporate debt ratings changes can therefore be
governed by conventional statistical inference, which suggests that once actual
losses are more than, say, two standard deviations from the mean initial estimate
the deal should be upgraded or downgraded.
Whats wrong with imposing those assumptions in the case of RMBS? First,
the midpoint estimate of the cumulative mortgage pool loss estimate, itself,
requires a distributional assumption. Second, the distribution of probable returns
around that midpoint is skewed, meaning that statistical inference on the basis of
standard deviations arising from the normal distribution is not relevant. Third, the
skewed distribution, itself, changes over time according to an unknown process
so that the distributional estimates, themselves, are subject to uncertainty. The
effect of those influences is graphically represented in Figure 15.
FIGURE 15: RELYING ON CORPORATE DEBT RATING METHODS

RESULTS IN LATE DOWNGRADES ON RMBS
1 2

The dashed black line in Figure 15 is the expected loss profile for the
mortgage pool. The skewed distribution along the dashed line represents the
statistical distribution of expected loss outcomes for the mortgage pool,
conditional upon the specific time period. The solid black line is actual mortgage
pool performance. The solid black lines position above the dashed line
represents substantial performance deterioration, in that actual losses are larger
than expected losses. The downgrade decision therefore centers on the question,
Are actual losses severe enough to represent an abnormal deviation from
performance substantial enough to justify a securities downgrade? Substantial
enough in this context is usually taken to mean something akin to two or more
standard deviations away from the mean.
The gray dashed line is the midpoint of the expected loss distribution for
corporate investments. The gray normal distribution is the distribution on
expected losses on corporate investment. Note that in the middle of the life of the
mortgage pool, the actual losses on the mortgage pool are not two standard
deviations away from the mean of the corporate loss distribution (point 1 in
Figure 15). That loss level, however, is already well into the tail of the skewed
(proper) mortgage pool loss distribution (point 2 in Figure 15), however,
suggesting that the RMBS should have been downgraded some time ago.
Standard normally-distributed loss assumptions used for corporate debt will
therefore downgrade RMBS much later than is warranted under accurate
distributional assumptions.
Additionally, since the skewed loss distributions for mortgage pool
performance are narrowing over time and the static fixed-income portfolio has no
chance of significant recovery, the RMBS have no chance of later upgrade. When
mortgage pools do not perform, therefore, the outcome is dramatic and final.
7. Implications: When Mortgage Pools Perform Normally, Credit

Enhancement Is Wasted
The narrowing width of cumulative mortgage pool loss distributions over

time (telescoping) also has implications for positive mortgage pool performance
scenarios. Earlier we showed that because mortgage pools are composed of fixed
income investments, portfolio performance has more downside risk than upside
risk leading to a skewed performance distribution. On the short side of that
skewness, the slightest increase in performance above expectations may in fact
lie well beyond the statistical distribution of expected returns. In that case
standard corporate bond rating techniques would not award a ratings upgrade to
that deal even though the deal may substantially warrant such treatment.
A more important result of the narrowing width of cumulative mortgage pool
loss distributions over time, however, is that loss scenarios that threaten default
become less probabilistically likely as time goes on in performing deals. As each
period passes, the pool seasons further and performance is more predictable.
Furthermore, there is less time for something exogenous to go wrong and
reduced risk of last-minute cash-flow diversion.
Figure 16 illustrates the effect. Even if actual cumulative losses lie the same
distance below expected losses throughout the life of the deal, the reduced width
of the performance distribution results in increased credit quality (decreased
probability of loss) over time.
FIGURE 16: CONSISTENT RMBS PERFORMANCE WARRANTS CREDIT

RATINGS UPGRADES AND CREDIT ENHANCEMENT IS WASTED

Upward ratings drift resulting from the telescoping cumulative loss

distributions also means that credit enhancement is wasted on deals that offer
merely consistent performance. Credit enhancement it is a decision about what
level of risk to cover or leave exposed. Credit enhancement is reflected in Figure
17 by the shaded area under the probability distribution that exceeds the loss
boundary, the area of which represents the probability that credit enhancement
will be necessary to cover losses to investors. The deal will hold insurance or
issue special securities to cover the risk of loss in that region. Hence, credit
enhancement helps prevent investors from experiencing losses above some
probabilistically-determined amount. Such coverage is relatively expensive,
however, because it carries a high risk of loss should performance sour.
FIGURE 17: EXPENSIVE CREDIT ENHANCEMENT IS WASTED IF THE

LOSS SCENARIOS IT COVERS ARE STATISTICALLY LESS LIKELY OVER TIME
Credit Enhancement
Cumulative Losses Loss Boundary

As time proceeds the cumulative loss distribution tightens around the mean.
Hence, in the event of positive performance the deal gets safer and saferthat is,
the amount of the shaded area under the statistical distribution that lies above the
loss boundary indicating credit enhancement coverage gets smaller and smaller.
Moving right across Figure 17, the level of loss that credit enhancement protects
against becomes increasingly unlikely. The expense of maintaining coverage
against such a level of loss exposure is therefore wasted.
8. Summary
In summary, because RMBS are constructed on the basis of mortgage pools

that consist of static portfolios of fixed-income investments that become
seasoned over time, performance over time becomes increasingly predictable.
That increased predictability results in RMBS ratings that telescope in quality
towards either default or AAA. Furthermore, all the tranches of securities
associated with a specific mortgage pool will migrate toward default or AAA
together. This all-or-nothing nature of the risk in structured finance is the source
of relatively high AAA yields (and yields across the credit spectrum) that attract
investors to the sector, as well as the source of concentrated defaults that have
historically hit various ABS and RMBS sectors to date. The problem with rating
RMBS therefore is not that the future is hard to predict. The problem is that the
traditional ratings process, when applied to RMBS, is being used to do things for
which it is not designed.
Most importantly, therefore, it is crucial to systematically refresh ratings
early in the life of a structured finance deal using the rich data set contained in
the servicers report in order to monitor the relationship between mortgage pool
seasoning and the pool factor (the number of mortgages left in the pool). There is
no analog for this function in standard corporate finance.
Below, we discuss specific examples of the properties outlined above. Actual

cases are presented to show that the lack of legal isolation further confounds risk
measurement. The main point is that a structured finance bond will either over-
or underperform a corporate bond with the same initial rating. In the structured
finance world Goldilocks is rarely satisfied: on the basis of current ratings
techniques, structured finance either runs too hot or too cold, but rarely just right.
C. Case Examples of Structured Finance Performance
Case studies can illustrate the phenomena described in the previous section.
We use ABS*TRAK to highlight how to identify key movements in pools and
securities performance relevant to the conclusions above. ABS*TRAK uses an
automated deal-by-deal data upload with precise transaction structures manually
coded. ABS*TRAK has distinct calibration and monitoring phases. In the
calibration phase, outputs on each transaction are scaled so the ABS*TRAK on
the most senior class of notes matches precisely the official rating agency rating.
Calibration insures internal consistency across time for all classes of notes
analyzed by the ABS*TRAK. In the monitoring phase, updates are generated
from monthly servicing data. Numeric outputs include the ABS*TRAK and the
theoretical credit curve, also called theoretical ABS*TRAK, which are
presented in the figures that follow as T.ABS*TRAK1. Since it is the
representative dynamics of the deal that are of interest, rather than the specific
deals themselves, the examples that follow maintain the issuers anonymity.
Figure 18 illustrates pool dynamics that should never legally occur. Merely
knowing that defaults cannot recover in a static pool, the downward spike in pool
balance is a red flag that something is amiss. The downward spike in annualized
periodic defaults suggests that perhaps some new accounts were added to
sweeten the credit quality. None of those dynamics, however, show up in the
simple cumulative default curve, however, because the trustee is managing the
pool to wash out the types of dynamics that are typically monitored by investors.
As an investor, however, the potential for pool management creates a legal
risk in addition to the fundamental (and obviously misunderstood) collateral risk.
Investors make the right choice here. Investors in the AA tranche bid up the
spread on the securities even though the loss dynamics were theoretically saved
by the trustees action (i.e., the red line remains a zero spread). Note that the y-
axis measures basis point discount on the security, so that 10,000 bps is a total
loss. The AA-rated A-1 tranche investors therefore face a near-total loss on
investment in this deal
Investors in the BBB-rated B-1 tranche act faster, and investors exposed to
the BB-rated C-1 tranche even faster still. Note that none of the prices recover
afterward, as expected by the analysis of the previous section. Both the B-1 and
C-1 investors face a total loss scenario, although the C-1 is a total loss at about
month 5 whereas the B-1 is a total loss at about month 24.
FIGURE 18: EXAMPLE 1, POOL AND SECURITIES PERFORMANCE
The example in Figure 19 shows what happens when defaults start becoming
fundamentally more complex. The annualized periodic default curve in this case
looks smooth, so there is not the previous worry about some kind of pool bailout
or trustee risk. Nonetheless, losses are mounting faster than anticipated. Evidence
for that assertion shows up in the cumulative default profile, which is still not
turning downward after 10 months.
What happened here was that bankruptcies hit the pool after funding so that
pool losses occurred sooner than expected. In essence, the deal was mis-
engineered in that the loss dynamics were miscalculated. This is a good example
of the ramp-up problem presented above.
Eventually, the actual cumulative loss profile catches up with historical
expectations, primarily due to the slowdown in annualized periodic defaults in
May and June. That realignment is reflected in a recovery in AAA-rated tranche
prices at about month 11. Prior to that date, investors were deeply discounting the
price due to concerns about the fundamental pool performance. Similarly,
investors in the A-rated tranche also regain confidence in month 12 and the
pricing of the B-1 tranche returns to normal at that point.
Figure 20 shows an example of mortgage loss dynamics. Here, annualized

periodic defaults rise in what appears to be a fairly normal seasoning pattern,
then spike suddenly, then turn down suddenly. Similar to the first deal, we as
investors would really like to know what is going on here. There seems to be
something abnormal in such quick movements.
In this case the cumulative default curve may be beginning to level off after
30 months, but we cannot be sure that is due to fundamentals because of the
spike and recovery in the annualized periodic defaults. Investors may not be sure
what is going on either. Investors in the AAA-rated B-1 tranche initially
discounted their exposures but then priced the securities well below relevant
historical risk exposures based on the ABS*TRAK model (the red line), which
shows a lot of residual risk in their exposure. Investors in the AAA-rated B-3
tranche are far less sanguine. Interestingly, even though those investors are lower
in the waterfall, they initially discounted the securities by less than the B-1
investors. The B-3 investors, however, are discounting the securities much later
in the life of the deal, when the loss dynamics are getting strange. The B-3
investors are therefore pricing risk, while the B-1 investors are not.
These examples show the sensitivity of RMBS prices to how well loss
assumptions hold up during the very uncertain early seasoning stages of the deal.
If the assumptions hold, the deal will perform well up to maturity. If not, the deal
will fall apart.
In summary, if capital structure and investment decisions can be changed to
ameliorate new risk (and the firm is willing to do so), it is fine for ratings to
remain largely fixed and static. If, however, either the capital structure or
investment decisions are fixed and static, ratings must move, sometimes fairly
often, to reflect new risk. If both capital structure and investments are fixed,
ratings become the chief mechanism of reflecting risk to investors.
Since corporations can change their capital structures and investment
strategies while corporate debt is outstanding, it is fine to statically rate a firm
with a dynamic asset portfolio and dynamic capital structure. Static ratings are a
problem for mortgage pool debt, that is, RMBS, however, because mortgage
pools are static firmsthat is, static portfolios of investments funded by static
capital structures. Mortgage pool trustees cannot change their investment
strategies or alter their capital structures to ameliorate new or unforeseen risk
without changing the legal nature of the investment arrangements.
It is easy to see that the limitations of ratings for mortgage pools with static
capital structures and investment strategies have the most pernicious effects in
markets where a high degree of opacity renders ratings the chief mechanism of
monitoring and evaluating risk.
Furthermore, the pernicious effects of static capital structure and investment
strategies are heightened when the static firms invest in fixed income assets like
mortgages and other types of consumer loans. The problem arises because fixed
income asset performance is bounded from above either the investor gets what
they originally contracted for (repayment of principal and interest) or takes a
loss. Unlike real investments in, say, equity, since the firm has no opportunity for
substantial upside gain the firm has no opportunity to build additional earnings
buffer than can help offset unforeseen risk.
In light of these observations, then, the minutiae of the RMBS and CDO
securities merely obfuscate a real potential for inadequate risk transfer that can
arbitrage regulations anchored on credit ratings, like ERISA and Basel II.
IV. THE COMPLEXITY OF RESIDENTIAL MORTGAGE-BACKED SECURITIES

MASKS INADEQUATE RISK TRANSFER
RMBS are sets of securities used to finance the purchase of a mortgage pool
from a mortgage originator. Like any firms securities, RMBS therefore pass the
risk of mortgage pool payments to individual investors.
Standard pass-through securities merely pass principal and interest payments
through to investors on a periodic pro rata basis. The creation of RMBS through
tranching, however, creates a much more complex set of securities. While it is
difficult to dispute that pass-through securities adequately pass mortgage pool
risk through to investors, it is much more difficult to estimate whether the
complex set of tranched RMBS securities passes the risk of the entire mortgage
pool through to investors. There are two primary reasons for that difficulty. First,
mortgage pools themselves are difficult to value due the commingling of default
and prepayment risk. Second, complex arrays of tranched RMBS are often thinly
traded, making it difficult to reconcile the total risk of the RMBS structure back
to the mortgage pool on the basis of market estimates.
Those two sources of the difficulty correspond to the two sides of the most
basic mathematical representation of portfolio risk. Standard MBA textbooks
present the simple two-asset portfolio standard deviation as:
n n n
p = wi2 i2 +
i =1 i =1
w w
j =1
i j i r
j ij
where the left-hand side of the equation, p, represents the total risk of the
mortgage pool. The right-hand side of the equation represents the total risk of the
portfolio of different tranched RMBS sold against the mortgage pool, where i
are the individual RMBS standard deviations and wi are the weights (tranche
sizes) of different RMBS constructed to finance the pool. The variable rij in the
equation is the correlation coefficient between the different classes of RMBS.131
One thing we know for sure: the total pool risk p does not go away by
merely being represented by a more complex set of securities. The sum of
portfolio risk in the securities sold to finance the mortgage pool therefore has to
equal the original risk of the mortgage pool. Thus, it must be that the right-hand
side is composed of securities that are specifically financially engineered to have
i and rij properties appropriately weighted wi in such a way as to accurately
reproduce the overall mortgage pool risk.
It is incredibly difficult to say, however, just what the right-hand side of the
above equation amounts to in real-world RMBS structures. If the actual structure
of RMBS securities is sold to investors on the basis of a combined portfolio
standard deviation that is less than p, risk has been masked. If the actual
structure of engineered securities and their weights is sold to investors on the
basis of a standard deviation more than p, risk has been overweighted (and the
deal will be uneconomical) to the issuer.
The problem of accounting for risk therefore becomes an exercise in
evaluating i and rij to make sure that the total risk of the set of engineered
131. If diversification is to be beneficial, r must be less than one, so that the

portfolio standard deviation will be below the mere sum of the standard deviations of its
component assets.
securities is equal to the total portfolio standard deviation, p. The difficulty of

evaluating p at the pool level, as well as the complexity of the securities
themselves makes such an exercise nearly impossible.
Fundamental changes in origination and servicing practices such as those
described in our earlier draft change the timing and predictability of the cash
flows that make mortgages valuable. When those changes occur unpredictably
over time or across issuers, thereby affecting the cash flows of some unknown
number of mortgages, RMBS become even more difficult to value. Hence,
changes in origination and servicing practices, along with the existing complexity
of RMBS, results in substantial opacity in the RMBS market.
A. Mortgage Pools Are Difficult to Value
Mortgage pools, like other fixed-income financial instruments, are valued as

the present discounted value of expected cash flows. Like most fixed-income
investments, mortgages are affected by default risk.132 Mortgages are also,
however, substantially affected by prepayment riskthat is, the risk that the
borrower will unexpectedly pay off the loan early. While a great deal is known
about measuring borrower default risk, relatively little is known about measuring
borrower prepayment risk. Whereas default risk is more a function of credit risk,
prepayment risk is more a function of market risk; in particular, factors like the
level of interest rates, the shape of the yield curve, volatility, seasonality and
market competition. Hence, prepayment risk creates substantial difficulty in
estimating the value of an RMBS as a function of expected cash flows on the
mortgage pool.
Default risk measurement, using consumer credit scoring models like the
FICO scores estimated by FairIsaac, is a relatively well-developed and mature
industry (though its application to those mortgage originations of recent
borrowers with limited credit history is cyclically untested and there is little
empirical information with which to assess its performance in a stressed
environment). Consumer loans and mortgages assess default risk by examining
borrower FICO scores of individual customers prior to approving a loan. FICO
scores are accepted by financial firms and their regulators as valid and
meaningful indicators of default risk.
While such measures of default risk are well-accepted in the industry, recent
trends have called the relevance of traditional FICO score reliance into question.
Fitch notes that, while 2006 vintage EPD loans have FICO scores that average
30 points higher than the 2003 vintage, increased borrower leverage, as
evidenced by high combined loan to value ratios (CLTVs) and lack of income
verification, has increased default risk for these higher FICO loans. Fitch goes
on to note, Over 50% of the 2006 EPDs have piggyback second liens.
Borrowers with the highest leverage tend to have higher FICOs.133
132. Default risk is the risk that a borrower will not repay, on time and in full, all
principal and interest as promised in the financial instrument.
133. FitchIBCA, Subprime Collateral Trends and Early Payment Defaults, Apr.
13, 2007.
Nonetheless, RMBS prospectuses routinely consider reporting the FICO

score distribution of the loans in the mortgage pool sufficient to show expected
levels of default risk.
Defaults are costly, but relatively rare. Prepayment risk is less costly, at least
in terms of directs costs, but far more prevalent. Calomiris and Mason
demonstrate a default rate of just under 4.3 percent in the 4.2 million FHA loans
underwritten from 1996 to 2002.134 By contrast, the prepayment rate in that
period was 67 percent. Figure 21 shows prepayment and default rates for the
Calomiris and Mason sample. It is immediately apparent that prepayment risk is
an entirely different order of magnitude than default risk.
FIGURE 21: PREPAYMENT AND DEFAULT RATES AS A FUNCTION OF

MORTGAGE DURATION
Source: Charles Calomiris & Joseph Mason, Endogenous and Exogenous Mortgage
Prepayments in an Optimal Stopping Framework (Working Paper 2007).
One can be tempted to dismiss prepayment risk by rationalizing that defaults

saddle investors with principal losses, whereas investors receive payment in full
with prepayment. The real problem, however, is that while investors are repaid
the full principal repayment, the stream of interest payments generated by the
principal end when they are most valuablethat is, when interest rates on
competing investments are low, a classic manifestation of re-investment risk.
Thus, prepayment risk, in tandem with textbook interest rate risk, creates a
double-edged sword. If interest rates in the economy rise, then the value of the
mortgage pool declines (standard interest rate risk). But if interest rates in the
economy fall, then mortgage borrowers prepay as they refinance (prepayment
risk). Hence, if interest rates move either way the mortgage investor loses.
Calomiris and Mason estimate that prepayment losses in their sample of 4.2
million FHA loans (equal to interest for the remaining expected life of the
134. Charles Calomiris & Joseph Mason, Endogenous and Exogenous Mortgage
Prepayments in an Optimal Stopping Framework (Working Paper 2007).
mortgage accrued at the difference between the rate on the prepaid mortgage and
rates available at prepayment) amount to just over $576 million while interest
losses due to defaults amount to only about $12 million.135
The problem with prepayment risk is that, unlike default risk, there is no
industry standard to measuring prepayment risk. Public Security Association
(PSA) models attempt to correct for prepayment risk but do not estimate it
directly. Figure 22 illustrates common prepayment vectors from Fitch IBCAs,
Rating U.S. Residential Subprime Mortgage Securities.136 Note that ARM
prepayment vectors spike considerably at the end of the fixed period.
FIGURE 22: COMMON PREPAYMENT VECTORS USED IN PREPAYMENT ANALYSIS
Source: Fitch IBCA, Rating U.S. Residential Subprime Mortgage Securities, Jul. 18, 2001.
Prepayment risk corrections affect the probable maturity of the bonds that
RMBS investors buy. When investors purchase RMBS securities, they are
therefore not only inferring default risk of mortgages in the pool, but also
inferring some probable maturity of their investments (when funds are repaid and
interest stops) as well.
Prepayment inferences about mortgage prepayments are based on ad hoc
corrections, not predictive prepayment models. The problem with formal
modeling is that unlike default risk, which is inversely related to economic
performance in a straightforward fashion, the double-edged sword relationship of
interest rate risk and prepayment risk creates a non-linear estimation
environment. Calomiris and Mason address the problem by estimating two
separate components of prepayment risk: one associated with prepayments
related to falling interest rates, and another associated with prepayments related
to other outside circumstances (like job transfers).
Calomiris and Mason call these two separate components of prepayment risk
endogenous and exogenous prepayments. Exogenous prepayments are
predicted as a function of attributes of the borrower and his or her local
135. None of this is meant to suggest that default risk is not as important as
prepayment risk. Total default losses (including losses on selling the home as collateral)
in the Calomiris and Mason sample amount to $4 billion. The main point, however, is
that repayment risk is costly and prevalent.
136. FitchIBCA, Rating U.S. Residential Subprime Mortgage Securities, Jul. 18,
2001.
community. Importantly, exogenous prepayments are initially estimated on

prepayments that occur in rising interest rate scenarios, in which we propose that
borrowers are not merely responding to refinancing their existing mortgage in an
advantageous interest rate environment. Coefficients from the exogenous
prepayments model are used to compute an exogenous prepayment score
(EPS). The EPS is then included in a second-stage model of endogenous
prepayments, which uses interest rate movement direction and volatility to
estimate endogenous prepayments as a function of borrowers option to prepay.
While Calomiris and Mason compute a number of variants on the model, the
results of the basic second-stage model are included in Table 1. No matter which
variant is estimated, EPS is always positive and statistically significant in the
second-stage models, indicating the difference in the exogenous and endogenous
prepayment decisions.
TABLE 1: REGRESSION RESULTS (DEPENDENT VARIABLE IS PREPAYMENTS)

Parameter Estimate Std. Pr >
Error ChiSq
Intercept -51.0834 0.1388 < .0001
EPS Score 0.5294 0.0010 < .0001
% Change in Mtg. Rates -3.1048 0.0225 < .0001
Standard Deviation of % Change in Mtg. Rates 2236.297 5.5339 < .0001
Source: Calomiris and Mason (2007).
The main point of this section is to show that the most basic steps in valuing
mortgage pools, and thus RMBS, are inherently difficult. Some elements of
valuation, like measuring default risk, are thought to be relatively clear-cut and
utilize accepted industry-standard modeling procedures. Other elements of
valuation, like measuring prepayment risk, are not well-understood and therefore
require subjective adjustments to assumptions about mortgage pool behavior.
While there are existing industry standards for correcting for prepayment risk,
there are not the types of well-developed models for prepayment risk such as
there are for default risk. Hence, even the most basic elements of mortgage pool
risk, the left hand side of the risk equation at the beginning of the section, are
difficult to value.
B. Complex Arrays of RMBS are Difficult to Value
RMBS are complex structured finance securities used to fund the mortgage
pools described above, with all the pools inherent default and prepayment
valuation difficulties. The complexity of structured finance products is meant to
smooth out some of the difficulties inherent in mortgage pool valuation to sell a
range of securities with different risk-return qualities to investors who value
those specific qualities (and tend to care less about other attendant valuation
difficulties). The inherent complexity of RMBS, coupled with fundamental
changes to underwriting and servicing standards, however, can also be used to
mask adverse changes to mortgage pool origination and performance and
therefore pose risk to RMBS investors and therefore risk to funding for socially
and economically important consumer mortgage originations.
The complexity of RMBS has increased as the statistical predictability of
collateral performance has become more established.
FIGURE 23: TRANCHES ISSUED IN EUROPEAN SECURITIZATIONS 1987-2003
Source: Maciej Firla-Cuchra & Tim Jenkinson, Why are Securitization Issues Tranched? (Oxford
University Working Paper 2005).
Figure 23 shows how RMBS and other structured finance products have
increased in complexity over time.137 The first private asset-backed security was
an RMBS issued by Bank of America in 1977, consisting of a simple pass-
through structurethat is, one tranche. As the industry matured and investors
became more comfortable predicting mortgage performance, RMBS became
substantially more complex.
TABLE 2: ISSUES WITH THE GIVEN NUMBER OF TRANCHES AS A PERCENTAGE OF

ALL ISSUES PER TYPE (MEAN NUMBER OF TRANCHES PER ISSUE)
Tranches per RMBS EQUIP CARDS AUTO OTHER
issue
1 20.5% 24.4% 58.1% 27.8% 53.8%
2 26.5% 41.5% 17.6% 55.7% 25.5%
3 19.6% 14.6% 20.3% 13.9% 9.0%
4 13.4% 12.2% 2.7% 1.3% 6.9%
5 10.2% 7.3% 1.4% 1.3% 2.1%
6 3.9% 1.4%
7 2.0% 1.4%
8 0.8%
9 0.2%
10+ 2.9%
Total issues 596 41 74 79 145
Note: Classification by type is according to the European classification of securitizations: RMBS
are residential mortgage-backed securities; Equip are securitizations of equipment assets; Cards
are credit-card securitizations; Auto are securitizations of auto-loans.
Source: Maciej Firla-Cuchra & Tim Jenkinson, Why are Securitization Issues Tranched? (Oxford
University Working Paper 2005).
Table 2 shows that other collateral types that began to be securitized well
after mortgages are far less complex. The first non-mortgage securitization was
equipment leases, followed by credit cards and auto loans, and more recently,
home equity, lease finance, manufactured housing, student loans, and synthetic
structures. All of those types of collateral illustrate tranching structures that are
measurably simpler than those for RMBS.
It is common to claim that RMBS became more complex as underwriting
technology became more efficient. Two examples of this are the movement from
standalone trusts to master trusts and the de-linking of tranches through issuance
trusts. Standalone trusts are simple and efficient for individual securitizations, but
woefully inefficient for repeated securitizations. The reason that standalone trusts
are inefficient for repeated securitizations is that each time an issuer wants to sell
more loans, it must create a new legal trust structure to house the loan pool and
issue the notes backed by that pool. Establishing an identical new trust structure
each time a new pool of loans is sold (often at least four times a year) repeatedly
incurs substantial fixed legal and administrative costs. Hence, a means by which
a firm could establish a shelf registration system for securitized assets
contributed a great deal of efficiency to the practice of securitization. By the late
1990s, therefore, most assets were being securitized in master trust structures.
Issuance trusts relieved the need to sell the entire structure of tranches at the
same time. In the past, the entire series of tranches had to be sold at once to
ensure that the lower-tier (junior) tranches provided the desired credit support for
the higher-tier (more senior) tranches. The problem is that widened credit spreads
resulting from adverse market shocks could (and did, during the 1998 Russian
bond default), occasionally shut down issuers ability to securitize assets at their
regular funding cycle. Those events led to legal developments that allowed
lower-tier tranches to be sold any time prior to higher-tier tranches as long as
higher-tier tranche maturities remained within those of the lower-tier securities.
Relieved of the constraint to sell all tranches of securities in the same market
environment, issuers could take advantage of favorable market conditions to
provide certainty to their regular funding cycle.
FIGURE 24: EXAMPLES OF ACTUAL RMBS FUNDING STRUCTURES
Source: ABSnet.
RMBS are currently the most mature and complex of consumer structured
finance products. Figure 24 shows some representative RMBS structures. The
examples show that RMBS routinely contain many tranches of securities.
Furthermore, those tranches include even more sophisticated features to adjust
for prepayment and other inherent mortgage pool risks, including complex and
difficult-to-value securities like interest-only and principal-only strips, sequential
pay securities, and planned amortization class bonds.
C. The Complexity of Valuing the Pool and the Array of RMBS Backed by the
Pool Makes it Nearly Impossible to Trace the Accuracy of the Risk Transfer
in the RMBS Market
The main point is that the complex arrays of RMBS represented in Figure 24
need to be constructed to meet the constraints that the total pool risk be
represented in the entire (very complex) structure of RMBS. Earlier we
represented the mathematical representation of a portfolio of securities as:
n n n
p = wi2 i2 +
i =1 i =1
w w
j =1
i j i r
j ij
Recall that the left-hand side of the equation, p, represents the total risk of
the mortgage pool. The right-hand side of the equation represents the total risk of
the portfolio of all the different tranched RMBS sold against the mortgage pool,
where i are the individual RMBS standard deviations and wi are the weights
(tranche sizes) of different RMBS constructed to finance the pool. The variable rij
in the equation is the correlation coefficient between the different classes of
RMBS.138
But this representation of risk is valid for only two classes of RMBS
securities, say equity and one class of debt. In practice, there can be up to 50 or
60 classes of debt and equity in a typical RMBS structure, each issued in
different proportions (weights) and with different, time-varying correlations (rij),
making it very difficult to estimate the true risk on the right-hand side.
Furthermore, we also showed that even the left-hand side is difficult to value,
given the complexities of default and prepayment risk. In that light, overly
complex arrays of RMBS can arguably add as much opacity to pool value as they
do efficiency to investors.
One thing we know for sure: the total pool risk p does not go away by
merely being represented by a more complex set of securities. The sum of
portfolio risk in the securities sold to finance the mortgage pool therefore has to
equal the original risk of the mortgage pool. Thus, it must be that the right-hand
side is composed of securities that are specifically financially engineered to have
i and rij properties appropriately weighted wi in such a way as to accurately
reproduce the overall mortgage pool risk. To do otherwise would be a
fundamental misrepresentation of risk.
In summary, RMBS are complex securities that are difficult to value.
Furthermore, RMBS are built on the backs of pools of mortgages, which
themselves are complex and difficult to value. Misrating RMBS and other
structured finance securities a substantial sector of the U.S. consumer credit
market at risk. Furthermore, fundamental changes to underwriting and servicing
standards are not easily identifiable in the inherent complexity of mortgages and
RMBS, posing risk to funding for socially and economically important consumer
mortgage originations. Below we demonstrate that the increased risk is magnified
by increasing concentration of CDO investments in lower-tranche RMBS
investments.
V. BOND RATINGS ALSO DO NOT ACCOUNT FOR COLLATERALIZED

DEBT OBLIGATION RISKS
CDOs fund a dynamic portfolio of assets on the basis of a static capital

structure. In this case, dynamic ratings like those for RMBS are still necessary
because the capital structure cannot be altered to accommodate unforeseen (or
just plain increased) risk. In fact, funding a dynamic investment portfolio with a
static capital structure breeds additional risk through moral hazard, where the
138. Recall further that if diversification is to be beneficial, r must be less than one,
so that the portfolio standard deviation will be below the mere sum of the standard
deviations of its component assets. Given that the value of all the RMBS is derived from
the same pool of mortgages, it is hard to argue that rij is substantially less than one in
many states of the world.
investment manager purposefully increases risk in order to maximize the return

on the static capital structure.
FIGURE 25: CDO CAPITAL STRUCTURE ARBITRAGE THROUGH

VINTAGE SUBSTITUTION
Source: FitchIBCA, Rating Stability of Fitch-Rated Global Cash Mezzanine Structured Finance
CDOs with Exposure to U.S. Subprime RMBS, Apr. 2, 2007.
Good examples of such capital structure arbitrage are unfolding as we speak.

According to FitchIBCA, mezzanine structured finance CDOs typically contain a
3-5 year reinvestment period during which new collateral can be substituted for
original collateral that prepays or defaults. As a result, since CDOs that were
created in 2003 faced high early prepayment and default rates recently they have
taken on risk from the 2005 and 2006 subprime vintages, which are so far
performing worse than the original 2003 vintage.139
Figure 25 shows how vintage substitution is forcing the 2003 and 2004
vintage CDOs to take on additional risk from the 2005 and 2006 vintage RMBS.
Because of this vintage substitution effect, as the 2003, 2004, 2005, and 2006
vintage RMBS season further, performance is expected to worsen. Hence, Fitch
expects RMBS and CDO downgrades to arise later in 2007.140
Even beyond the issue of capital structure arbitrage, such vintage effects
create a new and previously unanticipated risk. As investors have shunned new
subprime RMBS, home price appreciation and therefore mortgage underwriting
has slowed, reducing the volume of higher quality RMBS going forward. Hence,
there will be fewer high-quality later vintage assets for CDOs to purchase as they
release OC in their credit enhancements and replace earlier vintage investments.
As a result, returns will suffer as investors pay increasing premiums to chase
investments in a smaller pool of riskier assets in the sector.
It is again easy to see, therefore, that the limitations of ratings for CDOs that
fund debt pools with static capital structures and dynamic investment strategies
139. FitchIBCA, Rating Stability of Fitch-Rated Global Cash Mezzanine

Structured Finance CDOs with Exposure to U.S. Subprime RMBS, Apr. 2, 2007, at 5.
140. Id. at 5-6.
have the most pernicious effects in markets where a high degree of opacity
renders ratings the chief mechanism of monitoring and evaluating risk.
As before, the pernicious effects of static capital structure and dynamic
investment strategies are heightened when the static firms invest in fixed income
assets. The problem arises because fixed income asset performance is bounded
from above either the investor gets what they originally contracted for
(repayment of principal and interest) or takes a loss. Unlike real investment
projects, since the firm has no opportunity for substantial upside gain the firm has
no opportunity to build additional earnings buffer than can help offset unforeseen
risk.
Hence, CDOs, structured with a dynamic investment strategy but a fixed
capital structure, fixed income investments, and no market price signals require
dynamic ratings in order to adequately reflect risk. The main point is therefore
that, in the case of CDOs, bond ratings are again being used for something they
were not initially intended. In fact, ratings agencies continue to expand the
misuse of traditional ratings methods. The April 2007 IMF Global Financial
Stability Report warned that one of the most significant global risks outstanding
is the way that, the rating agencies continue to expand the application of their
ratings beyond the traditional credit risk domain.141
VI. THE COMPLEXITY OF COLLATERALIZED DEBT OBLIGATIONS FURTHER

MASKS INADEQUATE RISK TRANSFER
A. The Complexity of Valuing the Pool of RMBS and other Investments and the
Array of CDO Backed by the Pool Makes it Nearly Impossible to Trace the
Accuracy of the Risk Transfer in the CDO Market
Earlier we presented the difficulties in accounting for risk transfer in RMBS

backed by mortgage pools. CDOs are merely securities backed by pools of
RMBS and other fixed-income securities. The same risk equivalence between the
mortgage pool and the structure of RMBS must be maintained between the
RMBS and fixed-income pool and the CDOs. The main point is again that the
complex arrays of CDOs need to be constructed to meet the constraints that the
total RMBS and fixed-income pool risk be represented in the entire (very
complex) structure of CDOs.
Earlier we represented the mathematical representation of a portfolio of
securities as:
n n n
p = wi2 i2 +
i =1 i =1
w w
j =1
i j i r
j ij
Now the left-hand side of the equation, p, represents the total risk of the RMBS
and fixed-income pool. The right-hand side of the equation represents the total
risk of the portfolio of all the different tranched CDOs sold against the pool,
where i are the individual CDO standard deviations and wi are the weights
(tranche sizes) of different CDO securities constructed to finance the pool. The
141. IMF, Global Financial Stability Report, Apr. 2007, at 54.

variable rij in the equation is the correlation coefficient between the different
classes of CDO securities.142
CDOs again aggregate investments that, themselves, are difficult to value.
While CDOs differ in construction by type of collateral and purpose, most begin
with structures similar to RMBS. JP Morgans CDO Handbook (2001) illustrates
typical CDO tranche structure composed of some fixed and floating A and B
tranches supported by underlying C, D, and equity tranches. The top (A) tranches
are typically rated triple- or double-A, the next tier tranches (B) are rated single-
A, the next (C) triple-B, then double-B, with the equity typically not rated.
CDO funding structures, like RMBS, attempt to issue as many AAA-rated
securities as they can sell given the inherent risk in the underlying collateral.
CDOs attempt to issue as much class A, AAA-rated securities as possible
because those provide the deal with the cheapest funding. Lucas, Goodman and
Fabozzi suggest that typically about 77 percent of the securities in the structure
are class A securities and rated AAA, typically paying coupons about LIBOR
plus 26 bps.143 About 9 percent of the structure is class B securities, rated A and
paying about LIBOR plus 75 bps. The typical 2.75 percent of class C securities
are rated BBB and pay about LIBOR plus 180 bps. The riskiest rated bonds, the
class D securities, typically comprise about 2.75 percent of the structure, are
rated BB, and pay coupons of about LIBOR plus 475 bps. Equity, typically about
8 percent of the structure, is unrated and receives the residual cash flow from the
deal.
142. Recall further that if diversification is to be beneficial, r must be less than one,
so that the portfolio standard deviation will be below the mere sum of the standard
deviations of its component assets. Given that the value of all the RMBS are derived from
the same pool of mortgages, it is hard to argue that rij is substantially less than one in
many states of the world.
143. DOUGLAS L. LUCAS, LAURIE S. GOODMAN & FRANK J. FABOZZI,
COLLATERALIZED DEBT OBLIGATIONS: STRUCTURES AND ANALYSIS (2nd ed. Wiley
2006).
FIGURE 26: EXAMPLES OF ACTUAL CDO FUNDING STRUCTURES
Source: Bennett and Mason (forthcoming 2007).
Figure 26 shows actual CDO tranche structures. All the CDOs included in
Figure 26 are re-securitizations (also called structured finance, or SF, CDOs).
While most structures look similar to that RMBS, some, including those
illustrated in columns 3 and 8 are radically different.
The different funding structures reflect how CDOs fundamentally differ from
RMBS. In particular, CDOs are different from RMBS in at least six different
ways. First, whereas RMBS ABS are supported by static pools of underlying
assets, CDO pools are dynamically managed. Hence, the composition of the asset
portfolio can change dramatically through the duration of the CDO transaction.
Second, CDO transactions close before the pool of underlying assets is fully
formed. This aspect may be a benefit or a drawback. Beneficially, the manager
may be able to include in the pool greater diversity of collateral across industry,
credit, and vintage. As a drawback, however, like the classic corporate free cash-
flow problem, investors cannot be sure the manager will act as intended upon
investment. Third, CDOs are quite heterogeneous with respect to granularity.
Some CDOs may contain as little as twenty underlying assets, while others may
contain several hundred.144 Furthermore, several hundred underlying assets from
the same sector, that is, RMBS, does not add true diversification to the pool,
leading many in the industry to question the relevance of the traditional
calculations of diversity scores in contemporary CDOs.145 Because of the lack
of diversification, traditional actuarial loss methods applied to RMBS pools are
not properly applicable to CDO pools. Fourth, CDOs may illustrate more ratings
144. Note, however, that even several hundred underlying assets is still a relatively
small number compared to the hundreds of thousands of accounts underlying RMBS and
ABS pools.
145. See, e.g., Frank Partnoy, How and Why Credit Rating Agencies Are Not Like
Other Gatekeepers, in FINANCIAL GATEKEEPERS: CAN THEY PROTECT INVESTORS?,
(Yasuyuki Fuchita & Robert E. Litan, eds. Brookings 2006).
volatility than RMBS due to ratings migration on the underlying collateral or

manager trading. Fifth, while the heterogeneity of CDO asset pools adds some
degree of diversification to pool performance that is not possible in RMBS, it
may also increase opacity to investors. Last, since the CDO market is still
growing, secondary market trading is still limited. The development of secondary
market trading has been further hampered by the immense heterogeneity across
CDO underwriters, collateral managers, and asset types.146
As a result of those differences, CDOs fund portfolios of collateral using a
set of tranched securities seemingly similar to those found in RMBS, but using
even more complex and esoteric securities than those typically found in RMBS.
Section IV.B pointed out that our current understanding of market development
is that securities and structures underlying different collateral types evolve as
investors become more familiar with underlying collateral performance,
particularly the predictability of that performance. Hence, the increased
complexity of CDO structures and securities is not obviously rational in light of
the opacity and heterogeneity of collateral in CDO pools and the relative youth of
the CDO market.
CDOs, like RMBS, use securities like interest-only and principal-only strips
to address the different risks that those two sets of cash flows pose to investors.
Interest-only securities promise payment only while the loans are outstanding.
Once the loan exits the pool, whether through prepayment or default, interest
payment ends. Hence, there is great risk of non-payment in interest-only strips.
Principal-only strips return investors funds, but timing is the issue. Whether the
loan prepays or defaults (after which the collateral is sold), the investor usually
eventually recovers principal in full. Hence there is little risk of non-payment in
principal-only securities (although timing is still an issue: it is not uncommon for
recovery to take several years).
CDOs also, however, routinely issue controversial features like Payment in
Kind (PIK) terms in order to back up promised cash flows. A PIK term stipulates
that, in the event that investors cannot be paid current month interest they are
promised an increase in the par value of the bond to be repaid at maturity, that is,
an IOU in payment for an IOU. Recent deals have not offered interest on the PIK
feature, but sometimes offer greater PIK than the coupon foregone. Nonetheless,
PIK-able securities are inherently difficult to value, and attempting to adjust for
the lack of interest on the PIK component by making the PIK greater than the
foregone coupon just makes cash flow modeling of downstream tranches even
more difficult to ascertain with any degree of accuracy.147
The growing investor acceptance of CDO structures has been supported by
rating agencies willingness to rate these assets. Unlike other assets that rating
agencies rate, these assets are subject to considerable market risk, a risk which
rating agencies do not claim to be able to effectively rate. Recognizing these
issues, in May of 2005 former Fed Chairman Greenspan warned that the credit
risk profile of CDO tranches poses challenges to even the most sophisticated
146. See, e.g., S&P Global Cash Flow and Synthetic CDO Criteria, Mar. 21, 2002,
at 13-14.
147. See, e.g., S&P CDO Spotlight: Update to General Cash Flow Analytics
Criteria for CDO Securitizations, Oct. 16, 2006.
market participants and warned investors not to rely solely on rating-agency

assessments of credit risk.
Because many buyers of senior CDOs can only hold investment grade assets
they may continue to hold deteriorating and increasingly illiquid assets as long as
their ratings have not been downgraded. Because the market is OTC, investors
may incorrectly value these assets in their portfolio and be forced to recognize
large mark to market losses in a fast moving, liquidating market. As a case in
point, Janet Tavakoli points out that the blindness of rating agencies to super-
senior tranches can result in 2 different AAA tranches with different attributes.148
In fact, while one may be tempted to think that, due to their inherent
similarity, not to mention the relatively high exposure of CDO pools to RMBS
investments, CDOs and RMBS would be rated according to fairly similar
methods. Even so, Section B suggests one would be drastically wrong to assume
that RMBS and CDO ratings methodologies are similar, which leads to the
possibility for ratings arbitrage when creating CDOs from RMBS and other types
of structured finance.
B. Ratings Arbitrage: CDO Ratings Methods Are Looser than RMBS Ratings
Methods, Even when CDOs are Solely made up of RMBS
The advent of CDOs in the mid-1980s represented the first time ratings
agencies became consumers of their own ratings. With CDOs, ratings agencies
used published ratings on the constituent debt instruments in the collateral pool
along with the weights of different instruments in the capital structure, to rate the
CDO obligations produced on the basis of that pool. This was not too much
trouble in the beginning, because the investments carried in CDO pools were
almost exclusively standard corporate debt.
In the late 1990s, however, CDO pools began to carry a much wider variety
of debt from a much wider variety of sectors. Upon researching historical loss
incidence and severity across those different sectors, it was soon discovered that
the disparate sectors exhibited widely disparate performance.
A number of disclosure and arbitrage issues arose in attempting to properly
measure and adjust for the widely disparate performance. The disclosure
difficulties can be shown through the example of S&Ps experience (noting that
S&P is not unique in this regard). Nomura, in their Bond Rating Confusion,
report, writes, When the agency embraced a simulation-based rating
methodology for CDOs in 2001, it started using different implied asset default
rates for ABS and corporate bonds.149 However, the agency refrained from
disclosing a complete table of default rates over time for the separate asset
classes. Several months later, when S&P published its updated criteria for cash
flow and synthetic CDOs, it continued to disclose only a partial table.150 By not
148. Janet Tavakoli, GARP Risk Review Issue 22, January/February 2005 (If
everything else remained the same, but 2% of the portfolio defaulted, slightly more than
two percent of the first AAA tranche would not be deemed AAA. The AAA of the
second CDO presents a different picture, because 40% of the formerly AAA tranche
would no longer be deemed AAA.).
149. Sten Bergman, CDO Evaluator Applies Correlation and Monte Carlo
Simulation to the Art of Determining Portfolio Quality, S&P Special Report, NOMURA,
Nov. 12, 2006, at 6.
150. S&P, Global Cash Flow and Synthetic CDO Criteria, Mar. 21, 2002, at 46.
releasing complete tables of default probabilities for ABS and corporate bonds,
S&P temporarily sidestepped the problem of having multiple definitions
associated with its rating symbols. Later, when S&P addressed the treatment of
municipal bonds in CDOs, it acknowledged the stronger historical performance
of the municipal sector but it still refrained from publishing tables with different
idealized default rates for the different sectors.151
FIGURE 27: DEFAULT PROBABILITIES USED IN S&P CDO RATING CRITERIA
Source: Nomura, Bond Rating Confusion, June 29, 2006.
Figure 27 shows the default probabilities from version 3.2 of S&Ps software
for time horizons of three, five, and seven years. Figure 27 shows that over time
151. S&P, Finance Criteria Book, Apr. 12, 2005, at 305-307; Nomura, Bond
Rating Confusion, June 29, 2006, at 5-6.
horizons of both five years and seven years, S&P ascribes a higher default
probability to a CDO rated AA than to an ABS rated A. Over a three year time
horizon, a CDO rated AA has a higher probability of default than an ABS rated
A-. The tables, therefore, have some bizarre implications. According to Nomura,
Suppose you have a seven-year ABS rated AA+. According to the tables, the
instrument has an idealized default probability of 0.168%. If we repackage the
security (all by itself) and call the repackaged instrument a CDO, it ought to get a
rating of AAA because the idealized default rate for the AAA-rated CDOs is
0.285% over seven years.152
The ability to repackage financial securities and call them something else,
with no fundamental change to their risk characteristics, in order to achieve an
improved bond rating is the fundamental source of ratings arbitrage. As long as
ratings agencies mean different things when referring to CDOs, ABS, and
Corporate debt, incentives will continue to be skewed by risk arbitrage.
Furthermore, embedding ratings into regulation through ERISA and Basel II only
worsens the incentives to use opacity to the issuers benefit (and the investors
loss).
VII. MORTGAGE-BACKED SECURITIES AND COLLATERALIZED DEBT

OBLIGATIONS PROVIDE SUBSTANTIAL LEVERAGE TO THE U.S. MORTGAGE
INDUSTRY AND ECONOMIC PERFORMANCE
A. The Incredible Growth of the CDO Sector
The problem with the complex arrays of securities originated as CDOs is that
the CDO sector has grown so immensely in a short period of time. Figure 28
illustrates that annual issuance of CDOs has grown from nearly zero in 1995 to
over $500 billion in 2006. In fact, CDO issuance is growing so fast that new
issuance in 2006 amounted to approximately the total of the three preceding
years summed together.
152. Nomura, Bond Rating Confusion, June 29, 2006, at 5-6.

FIGURE 28: ANNUAL CASH CDO ISSUANCE

500
450
400
350
300
250
200
150
100
50
0
1987 1989 1991 1993 1995 1997 1999 2001 2003 2005
Source: Lucas, Goodman, and Fabozzi (2006).
Figure 28 also shows the risk of relying on CDO markets for funding growth
of underlying collateral underwriting. Figure 28 shows that CDO issuance
dropped off precipitously from 1998 to 2002, exceeding 1998 levels again only
in 2003. That drop-off arose from a combination of economic conditions along
with unforeseen difficulties in the corporate loan and bond markets and
manufactured housing, aircraft lease, franchise business loan, and 12-b1 mutual
fund fee structured finance sectors that accounted for a significant component of
CDO investments at the time. CDOs have since moved out of those sectors, and
into RMBS and commercial mortgage-backed securities (CMBS).
The kind of market dynamics illustrated in 1998 suggest the potential for
high volatility in sectors that rely principally upon securitization and re-
securitization through CDOs for funding.
B. By Investing Heavily in Junior RMBS and ABS Tranches, CDOs Provide a

Substantial Part of the Base for the Roughly 10:1 Leverage in Todays RMBS
Market
The potential for high funding volatility arises because of the structure of
RMBS and the types of RMBS that CDOs hold. The structure of RMBS
providing funding for a specific pool of mortgages is composed of an array of
debt securities that pay investors principal and interest sequentially. If enough
principal and interest remains after paying the first class of investors, the second
is paid. If money remains after that, the third class is paid, and so on, and so
forth. In this manner, the last class of securities to get paid bears the majority of
the risk. Without investors willing to purchase the last classes of securities
typically, about 10 percent of the securities sold the prior classes bear the risk.
If the prior classes are not willing to bear the risk, the other 90 percent of the
mortgage pool cannot be funded, that is, the mortgage originator cannot sell the
loans. Hence, the last classes of securities are providing about 10:1 leverage for
the structure of RMBS, so that every dollar of lower-tranche RMBS supports
about $10 of higher-tranche RMBS.
Specific types of CDOs have arisen that specialize in holding such risky
classes of securities have become popular in recent years, providing a great deal
of funding for lower-tranche RMBS at that 10:1 leverage ratio. But since so
much lower-tranche RMBS has been sold to those CDOs, the CDO sector now
holds a very high concentration of mortgage risk. If RMBS begins to default and
the CDO sector restricts investments in RMBS or shifts out of RMBS, the
mortgage industry loses funding of $10 for every $1 CDOs no longer want to
buy. This scissors effect of leverage produces very volatile effects on the
market that is leveraged, in this case, the mortgage market.
So just how much lower-tranche RMBS do CDOs hold? The FDIC reports
that 81 percent of the $249 billion of CDO collateral pools issued in 2005, or
$200 billion, was made up of residential mortgage products. (FDIC Outlook, Fall
2006) Moodys CDO Asset Exposure Report for October 2006 reveals that 39.52
percent of the collateral within the 678 deals covered by Moodys consists of
RMBS, just over 70 percent of that in subprime and home equity loans and the
other 30 percent in prime first-lien loans. Figure 29 confirms similar magnitudes
from a smaller sample of CDOs monitored by Fitch.
FIGURE 29: SUBPRIME RMBS COMPOSITIONS IN CDOS GREW QUICKLY

OVER RECENT YEARS
It is clear that CDOs hold a lot of RMBS, but what matters is how much of that is
lower-tranche RMBS, which is the source of the scissors effect. Moodys CDO
Asset Exposure Report for October 2006 reveals that 70 percent of collateral in
the pools underlying the 2005 resecuritization CDO vintage was below AAA-
rated, and the largest ratings cohort, at 40 percent, was Baa. About 10 percent of
the 2005 vintage collateral pool was rated below Baa. Overall, about 75 percent
of collateral in the pools underlying resecuritization CDOs was below AAA-
rated, the largest cohort being, again, Baa at 42 percent. About 16 percent of
collateral was rated below Baa. Table 3, from Moodys, shows that overall
weighted average rating factor (WARF) for the top collateral types for the
resecuritizations is 225, which equates to about a Moodys Baa1 rating.
TABLE 3: TOP COLLATERAL TYPES IN RESECURITIZATION CDOS, 2005

(ALL VINTAGES)
Source: Moodys, CDO Asset Exposure Report, Oct. 2006.
Again, Figure 30 confirms those magnitudes.
FIGURE 30: RATINGS DISTRIBUTION OF RMBS IN CDO PORTFOLIOS
Given the above observations, it is reasonable to infer that about 70 percent

of the $200 billion, or about $140 billion, in RMBS purchased by CDOs issued in
2005 is below AAA. As we demonstrated earlier, only some 10 percent or so of a
typical RMBS financing structure is made up of lower-tier (junior) securities.
Those lower-tier (junior) tranches provide the desired credit support for the
higher-tier (more senior) tranches. In other words, the 90 percent of the RMBS
structure above the lower-tier (junior) tranches cannot be sold until those 10
percent lower-tier (junior) tranches are sold.
Because the 90 percent of higher-tier (senior) securities in an RMBS cannot
be sold without selling the 10 percent of lower-tier (junior) securities first, even a
small decline in CDO funding of mezzanine RMBS investments relative to the
total RMBS market can have a large effect on RMBS funding, and therefore
consumer mortgage funding.
FIGURE 31: HOW MUCH AND WHAT KIND OF RMBS ARE IN CDOS?
81 percent of the $249 billion of CDO collateral pools issued in

2005, or $200 billion, was made up of residential mortgage
products. (FDIC Outlook, Fall 2006)
Among RMBS in CDOs, 70%-75% held was below AAA-rated.
(Moodys CDO Asset Exposure Report, October 2006)
$200 billion of RMBS in CDOs x 70% below AAA =
$140 billion of lower-tranche RMBS in CDOs
SIFMA puts total RMBS issued in 2005 at $1,326 billion.
Assuming 90% AAA in all 2005 RMBS, that leaves a total of
$133 billion in lower-tranche RMBS issued in 2005
Point: CDOs purchased more lower-tranche RMBS in 2005 than
was issued in that year.
How large of an effect? SIFMA estimates that about $1,326 billion was
issued in private RMBS in 2005. If 10 percent of that is lower-tier (junior)
securities, then about $133 billion in lower-tier securities supported the rest of
the $1,193 billion.
Hence, the CDO market purchased more mezzanine RMBS in 2005 as was
actually issued that year. Furthermore, and crucially, the relatively small amount
of RMBS purchased by the CDO market provided support for the rest of the
$1,193 billion issued in private RMBS during the entire year of 2005.
In summary, the CDO market adds liquidity to the RMBS market in a highly
leveraged fashion by funding lower-tranche RMBS securities, and the experience
of the ABS markets in the early 2000s illustrates that the liquidity provided by
CDOs is very fragile. As is common in highly leveraged markets, the scissors
effect of leverage can create substantial market volatility when investors enter
and leave a highly leveraged market quickly. Since CDO difficulties arising from
RMBS ratings deterioration is expected to be the proximate cause of mortgage
market de-leveraging, we turn to analyzing the relationship between RMBS
ratings and CDO ratings.
C. CDO Ratings Changes Follow (Scarce) Ratings Downgrades for Constituent

RMBS Collateral
The main problem we have described is that the RMBS market is built upon
the shaky statistical predictability of mortgage pool performance. The CDO
market then builds upon the shakier foundation of the statistical predictability of
RMBS performance to provide additional market liquidity.153
Preliminary evidence for this view lies in the relationship between ratings
changes in CDO markets and underlying collateral, that is ABS and RMBS,
markets. Given recent events, we now know that there are substantial numbers of
defaults and near-defaults in RMBS mortgage pools. It is only a matter of time,
153. As before, as the performance of mortgages shifts due to fundamental changes

in origination and servicing practices, investors may be surprised to find the mortgage
claim they purchased is based on a pool of loans with very different statistical
performance properties than previously experienced or expected.
therefore, before they accumulate to levels that will threaten rated mezzanine
RMBS that is the investment of choice in many CDO pools. Many people are
therefore asking when the RMBS defaults will hit CDO returns. In an opaque
market prices may already be at distress levels we wont know, however, until
investors try to sell.
We can infer when the defaults will hit CDO performance by reviewing the
lessons already learned from the NERA report in 2003. The NERA report
analyzed the effects of notching in the ratings industry. Notching refers to the
industry practice whereby one agency adjusts ratings of structured finance
collateral from other agencies for the stated reasons of (1) bringing them in line
with ratings it believes it would have assigned to the collateral and (2) adjusting
for uncertainty and perceived differences in monitoring practices.154 The study
came about at a time when ratings agencies were increasingly asked to rate
collateralized debt obligations with underlying collateral pools that include
structured finance securities rated only by other rating agencies.
The NERA report is important for understanding present conditions in CDO
markets because it points out the need for one ratings agency to do substantial
additional research before integrating ratings of another agency that relate to, say,
underlying collateral in a CDO. First, the outside rating change must be adjusted
to be comparable with the CDOs ratings agency. Then, the CDOs ratings
agency needs to analyze the CDOs cash flow implications of the change in the
single underlying collateral instrument. Last, the CDOs ratings agency needs to
decide whether to take action on the CDO itself. All those steps take additional
time when the structures of the securities of concern are more complex.
In footnotes to their CDO Asset Exposure Report, Moodys notes that it
can take anywhere from three to seven weeks to normally incorporate another
ratings agencys change into their own CDO ratings.155 Hence, it would be
expected that CDO ratings changes considerably lag RMBS and ABS ratings
changes due to opacity between markets and across ratings agencies.
154. Andrew Carron, Phoebus J. Dhrymes & Tsvetan N. Beloreshki, Credit

Ratings for Structured Products: A Review of Analytical Methodologies, Credit
Assessment Accuracy, and Issuer Selectivity among the Credit Rating Agencies. NERA
Economic Consulting, Nov. 6, 2003 at 1.
155. Moodys, CDO Asset Exposure Report, Oct. 2006.
FIGURE 32: THREE-MONTH MOVING AVERAGE NUMBER OF CDO, RMBS, AND

ABS RATINGS CHANGES
Figure 32 graphically illustrates that CDO downgrades followed ABS

downgrades after the fallout in ABS in 2001-2003. Before 2003, CDOs
experienced significant difficulties with ABS and lagged ratings changes. Those
difficulties led to the NERA study discussed above. Figure 32 shows that in the
periods that followed, the lagged relationships became much more systematic.
Those results can also be shown through statistical VAR analysis of the
relationship between ABS and CDO downgrades
TABLE 4: RESULTS OF VAR ANALYSIS OF THE RELATIONSHIP BETWEEN ABS

AND CDO DOWNGRADES FROM JANUARY 2005 TO DECEMBER 2006
Dependant Variable: CDO

CDO(-1) 0.024350
[ 0.23856]
CDO(-2) -0.047252
[-0.45778]
CDO(-3) -0.024940
[-0.19261]
CDO(-4) -0.027687
[-0.20357]
CDO(-5) -0.051774
[-0.39481]
ABS(-1) 0.100261
[ 1.35114]
ABS(2) 0.109789
[ 1.47095]
ABS(-3) 0.179819
[ 2.47077]
ABS(-4) 0.116152
[ 1.57518]
ABS(-5) 0.234360
[ 3.25081]
C 1.391791
[ 1.31038]
Note: ( ) represents lag length; [ ] provides the t-
statistics; CDO is the depended variable; C is constant.
Table 4 shows the coefficients of the statistical VAR analysis of the

relationship between ABS and CDO downgrades, weekly, from January 2005 to
December 2006. The coefficient results in Table 4 clearly indicate that CDO
downgrades follow ABS downgrades in the aggregate.
FIGURE 33: IMPULSE RESPONSE FUNCTION OF THE RESPONSE OF CDO TO

SHOCKS IN ABS WITH (+) OR () 2 STANDARD DEVIATIONS
Figure 33 shows the impulse-response function generated by the VAR, which

demonstrates a long-lasting and significant positive correlation between ABS and
CDO downgrades. At 12 weeks, ABS downgrades explain about 23 percent of
CDO downgrades in the aggregate.
D. The CDO Sector will Drop Collateral Sectors that Underperform
Recent historical lags between ABS/RMBS downgrades and CDO

downgrades suggest a similar lag will occur due to the current mortgage mess. As
yet, there are not enough RMBS downgrades to manifest a similar effect, but
analysts expect the manifestation to soon become evident.
According to Steve Kolyer, a partner at law firm Clifford Chance, which is
an outside counsel to S&P, Ratings may be cut on collateralized debt
obligations by this summer as the subprime loans that back the debt structures
continue to sour. After the losses become evident, there will be a
reassessment of the credit grades of a lot of the instruments that were sold out of
the CDOs. That's when there will be further dislocation.156
Credit downgrades will cause a great deal of troubles in markets. If rating
companies begin to downgrade securities to junk status, some investors may be
forced to sell assets they bought when they were initially rated high-grade.
Concerns about delinquencies and defaults on high-risk mortgages spurred
weaker performance of subprime mortgage bonds and raise worries that
insurance companies and pension may be at risk. Last month, Moody's cut
ratings on nine classes of subprime bonds sold by securities units of UBS AG and
cited potential cuts on dozens more from other issuers.
The worry is that CDOs pull out of RMBS, even for a short period, and the
scissors effect described above leads to dramatically decreased funding for
mortgage originations. Historically, CDOs have fled distressed sectors without
looking back. Prior to 2003, CDOs invested heavily in manufactured housing,
aircraft lease, franchise business loan, and 12-b1 mutual fund fee ABS. CDOs
with heavy exposure to those collateral classes took a beating when collateral
underperformance and fraud revealed heavy losses in the pools and,
subsequently, a great many defaults on ABS in those sectors.
More importantly for our purposes, however, is the fact that the collateral
sectors that caused difficulties for CDOs in 2003 shrunk considerably afterward.
The manufactured housing, aircraft lease, franchise business loan, and 12-b1
mutual fund fee ABS sectors are significantly smaller than they were when
CDOs were pouring in during 1999-2001. We argue that the shrinkage in those
sectors arose from decreased funding by the CDO markets.
We therefore maintain that dramatic shrinkage in the RMBS sector is likely
to arise from decreased funding by the CDO markets as defaults accumulate. Of
course, mortgage markets are socially and economically more important than
manufactured housing, aircraft leases, franchise business loans, and 12-b1 mutual
fund fees. Decreased funding for RMBS could set off a downward spiral in credit
availability that can deprive individuals of home ownership and substantially hurt
the U.S. economy.
The point made in the sum of this and the preceding section is that the CDO
market adds liquidity to RMBS and ABS markets in a highly leveraged fashion
by funding lower-tranche RMBS securities. According to Lucas, Goodman, and
Fabozzi, however, that liquidity is very fragile, and the leverage provided by
CDOs creates a scissors, or unwind, effect:
156. Walden Siew, Subprime Fear to Spur CDO Downgrades-Clifford Chance,

REUTERS, Apr. 26, 2007.
The CDO market is opportunistic in the way it drops collateral types that
are out of favor with investors and picks up collateral types that are in
favor with investors. The best example of this is the switch out of poor-
performing high-yield bonds and into well-performing high yield loans
between 2001 and 2003. Also, certain types of ABS present in SF CDOs
from 1999 through 2001 disappeared from later vintages: manufactured
housing loans, aircraft leases, franchise business loans, and 12b-1 mutual
fund fees. All of these assets had horrible performance in older SF CDOs.
In their place, SF CDOs have recently focused more on RMBS and
CMBS.157
Hence the degree of leverage inherent in CDO funding, along with the potential
for high volatility in that funding, introduces the potential for public policy
issues.
E. Domestic Links between Mortgage Markets, RMBS, and CDO Funding and
the Housing Sector and Economic Growth
In August 2006, Fitch Structured Finance published a special report on U.S.

Subprime RMBS in Structured Finance CDOs. That report pointed out a number
of the changes to mortgage origination and servicing standards and gave some
thought to possible implications for CDOs. In the period of time that has
followed the Fitch report many of the changes to mortgage origination and
servicing standards have become manifest.
As a result of recent manifestations of risks arising from changes to mortgage
origination and servicing standards, in November 2006 the Markit Group
reported that there was an interest shortfall on two bonds underlying Markits
ABX-HE 06-1 BBB and BBB- indices of RMBS performance. More recently,
the Wall Street Journal reported on January 27 that the ABX-HE 06-2 index had
dropped 10 percent over the last six months, reflecting heightened default risk in
the sector.158 Hence, the mortgage defaults that began occurring six or more
months ago have become evident in investor pricing of RMBS instruments.
The consensus view seems to be that faced with slowing demand and
shrinking profit margins, subprime lenders tried to maintain volume as the
housing market was faltering in late 2005 and 2006 by making riskier loans.
Those risks are now manifesting themselves in lower profits for issuers, resulting
in bankruptcy for some and significantly higher loan loss provisioning for those
that remain. RMBS defaults can be expected to result in a significant decline in
157. DOUGLAS L. LUCAS, LAURIE S. GOODMAN & FRANK J. FABOZZI,

COLLATERALIZED DEBT OBLIGATIONS: STRUCTURES AND ANALYSIS 5 (2nd ed. Wiley
2006).
158 James R. Hagerty & Michael Hudson, Mortgage-Default Risks Rattle Bond
Investors, WALL ST. J., Jan. 27, 2007, at B4. A decline in the ABX-HE signals that sellers
of these insurance contracts are demanding larger payments to compensate for what they
see as a higher risk of mortgage defaults, which would reduce the value of mortgage
securities.
CDO funding for mezzanine RMBS tranches and, ultimately, a significant

decline in funding for residential mortgages. 159
Decreased funding for residential mortgages can be expected to affect
housing starts and home purchases, which affect the construction and building
and home products industries and are key to economic performance. Reduced
economic performance further exacerbates defaults, leading to a feedback
mechanism that can produce a prolonged slump in US economic performance.
Peter Horndahl and Christian Upper of the Bank for International
Settlements, initially reported that while the decline in the U.S. housing sector
did not seem to impact RMBS spreads, the ABX:HE, a group of synthetic
indexes of U.S. home equity ABS, moved sharply lower at the end of 2006.160
Figure 34 shows that RMBS markets are now beginning to illustrate the effects
of high defaults in the mortgage pools that have made recent headlines.
FIGURE 34: CDO ISSUANCE AND U.S. HOME EQUITY ABS INDICES
Source: BIS Quarterly Review, Dec. 2006.
RMBS issuance will become more expensive, perhaps prohibitively so, as

spreads continue to widen as illustrated at the end of 2006. As prices on the
ABX.HE index trend down, bond yields trend higher as investors demand more
return as they realize the increased risks associated with RMBS investments.
Note that beginning about August 2006, BBB- to AA spreads began widening,
pausing only briefly about October. That spread is generally referred to as the
price of risk
DAmato shows that the price of risk rises with increased defaults, lower
housing starts, decreased payrolls, poor economic performance, and lower CDO
159. See, e.g., Carrick Mollenkamp, In Home-Lending Push, Banks Misjudged

Risk: HSBC Borrowers Fall Behind on Payments; Hiring More Collectors, WALL ST. J.,
Feb. 8, 2007, at A1.
160. Peter Horndahl & Christian Upper, Overview: Markets Anticipate an Orderly
Slowdown, BIS Q. REV., Dec. 2006.
issuance.161 DAmatos results are reproduced in Table 5. DAmatos mechanism

feed upon itself, wherein housing starts drag down nonfarm payrolls, which in
turn drag down the real policy rate gap, followed by rising mortgage defaults and
decreased CDO issuance. Decreased CDO issuance reduces funding for
mortgages, which drags down housing starts, nonfarm payrolls, etc so that the
cycle perpetuates itself. Such a macroeconomic propagation mechanism typically
will not be the shock that starts a recession, but is the force that makes recessions
long and deep.
161. Jeffery DAmato, Risk Aversion and Risk Premia in the CDS Market, BIS Q.
REV., Dec. 2005.
TABLE 5: CDO RISK PREMIUMS AND CREDIT SPREADS AND

MACROECONOMIC PERFORMANCE
Source: Jeffery DAmato, Risk Aversion and Risk Premia in the CDS Market, BIS Q. REV., Dec.
2005.
F. Both Domestic and International Markets are Already Discounting RMBS,

and CDOs
So far we have seen many of these expectations play out in markets already.
Ratings agencies continue to say that the worst is over, only to revise their
assumptions downward over and over. By late March, S&P was raising their loss
assumptions on 2006 vintage subprime loans another 125 basis points, to 7.75
percent overall. At the same time, S&P continued to maintain in reports that most
investment-grade bonds originated last year would remain protected, even as
underlying loan performance would be the worst in history. Most can only be
interpreted in todays environment to mean more than 50 percent, since S&P

admitted the revision may have a material impact on the ratings of
collateralized debt obligations. After much hand-wringing by some sources
following our earlier draft, S&P admitted that residential mortgage bonds made
up an average 73.8 percent of CDOs of asset-backed securities collateralized by
mezzanine structured finance tranches last year, up from 42 percent in 2003.162
By late April, however, many were tiring of the ratings agencies updates,
creating a reputation dilemma for the agencies just prior to their earnings
announcement dates. Earnings at both Moodys and S&P were expected to be
low due to fewer bonds to rate in the housing slowdown and the reputational risk
they have suffered in the continuing mortgage mess, wherein the market value of
many subprime-mortgage-backed bonds continues to fall in anticipation of
further severe increases in defaults.163
While S&P and Moody's continue to say most of these bonds are well-
cushioned from losses, on April 20, Moodys again announced that losses among
2006 subprime-loan pools will be somewhat higher than our initial
expectations. Moodys also said it expects more ratings volatility on weaker
subprime-mortgage bonds.
The ratings agencies both say they have been adapting their models to the
environment. But the repeated erosion in agency forecasts "throws up a red flag,"
says Christian Stracke, an analyst at independent debt-research firm CreditSights.
The agencies are tacitly admitting that the scenarios they have been peddling
were unrealistically positive.164
At the same time, the problems refuse to remain contained in the narrow
subprime sector, as predicted by many industry experts. While many still deny
the trends, defaults continue to rise in the alt-A mortgage segment,165 commercial
mortgages,166 and commercial loans.167 All of those sources are documenting the
loan products sold to subprime borrowers are staples of the overall market.
Others have noted that mortgage lending has replaced traditional auto and
credit card lending through home equity loans and home equity lines of credit,
upsetting the traditional view that borrowers will default on those obligations
first providing a canary in the coal mine to warn of impending risk. In fact,
there is little difference between defaulting on a credit card and a second-lien
home equity loan: often the equity in the second lien is too small to fight over
in foreclosure, so the lender has little choice but to treat the exposure as
unsecured. In a recent report, Alan Greenspan estimated that cash-out refinancing
162. S&P Raises 2006 Subprime Mortgage Loss Expectation, REUTERS, Mar. 27,
2007.
163. Serena Ng, Subprime Cloud Overshadows S&P, Moody's, WALL ST. J., APR.
24, 2007, AT C1.
164. Id.
165. Vikas Bajaj, Defaults Rise in Next Level of Mortgages, N.Y. TIMES, Apr. 10,
2007.
166. Jody Shenn, Commercial-Mortgage Risk Forcing Change, Moodys Says,
BLOOMBERG, Apr. 11, 2007.
167. Buddy, Just Hand Over That Dime, ECONOMIST, Mar. 31, 2007; Standard &
Poors Warns of Loose Standards in Commercial Lending: Flood of Liquidity into
Interest-only Loans Cited, INMAN NEWS, Apr. 11, 2007.
and home equity lending boosted consumption expenditures by as much as 3

percent during 2006.168
Faced with the kind of spikes in credit spreads in mortgage-backed securities
and corporate debt markets of all types represented in Figure 35, it is hard to
deny that markets are pricing risk again.
FIGURE 35: MORTGAGE-BACKED SECURITY SPREADS, RISK PREMIA, AND

EURODOLLAR FUTURES
Source: IMF Global Financial Stability Report Statistical Appendix, Apr. 2007, Ch. 1, pp. 34-5.
The IMF now attributes the March mini-crisis to a response to perceived

risks in the U.S. outlook. U.S., Japanese, and European equities fell in tandem as
the increase in economic uncertainty was reflected in lower equity prices and the
rise in equity volatility. Shares of financial companies declined on concerns over
potential exposure to credit markets.169
All the while, however, Federal Reserve Monetary Policy is backed against a
wall. Inflation risk remains, though perhaps only in a manner similar to the
worries of the Federal Reserve in the early- to mid-1930s, before tightened
reserve requirements created the recession of 1937 before recovery from the
Great Depression was complete. That said, even if the FOMC wanted to lower
rates they do not have much room to do so. So monetary policy remains stagnant.
Congress wants to legislate a solution, but that process will be long, costly,
and fundamentally meaningless in the end. Furthermore, the process will not be
revenue neutral, which means that it will drive up inflation. While that may not
happen through conscious decision of policymakers, we argue that the process
has already begun.
As evidence, the mortgage mess is already showing up in exchange rates and
analyst forecasts. Since the FOMC is holding interest rates constant, something
else must move. So far, the dollar already is down 3 percent from a year earlier.
Although such movement should help U.S. exports, the Conference Board most
recently reported that U.S. consumer confidence is now beginning to lag. Job
growth is the only element that is propping up the economy and even that may
now be weakening.170
168. Brian Blackstone, Greenspan Sees Spending Link to Home Equity, WALL ST.
J., Apr. 24, 2007; Abby Goodnough, Housing Slump Pinches States in Pocketbook, N.Y.
TIMES, Apr. 8, 2007.
169. IMF Global Financial Stability Report Statistical Appendix, Apr. 2007, at 36.
170. Christopher Conkey and Phil Izzo, Consumers May be Getting Tired: Weight
of Gasoline Prices, Housing and Job Markets is Piling Up, WALL ST. J., May 9, 2007.
We see the kind of developments illustrated in Figure 36 as the carry trade

unwinds. Neil Mellor, currency strategist at Bank of New York, maintained that
after a brief period of improvement in sentiment for risky assets, the second
phase of the deleveraging process has duly arrived.171
FIGURE 36: EXCHANGE RATES FOR SELECTED MAJOR INDUSTRIAL COUNTRIES
Source: IMF Global Financial Stability Report Statistical Appendix, April 2007, Ch. 1, p. 142.
In essence, then, the chosen policy approach is evidently to allow exchange

rate movements create the inflation that the Fed will not or cannot create with
monetary policy. Inflation relative to world exchange rates will deflate U.S.
prices and help the country remain competitive with the rest of the world. Or
perhaps the U.S. will become just another affordable playground for the global
riche.
In summary, the structural changes in mortgage origination and servicing
have interacted with complex RMBS and highly volatile CDO funding structures
to place the U.S. housing market at risk. Equally as important, however, is that
housing market weaknesses feed back through financial markets to further
weaken financial instruments backing todays CDOs. Decreased housing starts
171. Peter Garnham, Dollar Continues to Lose Ground, FIN. TIMES, Mar. 15, 2007.
that will result from lower liquidity in the RMBS sector will further weaken
credit spreads and depress CDO and RMBS issuance. This feedback mechanism
can create imbalances in the U.S. economy that, if left unchecked, could lead to
prolonged domestic economic implications for U.S. standing in the world
economic order.
VIII. POLICY IMPLICATIONS
The potential for prolonged economic difficulties that also interfere with
home ownership in the United States raises significant public policy concerns.
Already we are witnessing restructurings and layoffs at top financial institutions.
More importantly, however, is the need to provide stable funding sources for
economic growth. The biggest obstacle that we have identified is lack of
transparency. The structural changes noted in our previous draft largely went
unnoticed by RMBS investors until only recently. We argue that those changes
went unnoticed largely because of the existing complexity and valuation
difficulties underlying todays RMBS markets.
But policymakers and ratings agencies are still reluctant to examine some of
the key frictions that have caused the present mortgage mess.
Congress is calling for increased loan mitigation without thought to the vast
heterogeneity in mitigation standards existing in todays market nor a sound
analysis of best practices in the field.
While the mortgage industry is pulling back from high LTV products, which
makes perfect sense in an economic climate with little home price appreciation,
legislators are pushing to expand the high-LTV sector, even with little hope of
owners building equity to incentivize repayment, much less any limit to limit
cash-out refinancing that arbitrage the mortgage interest tax deduction and erode
the buildup of equity on government-insured mortgage products.
Some are even proposing bailouts for overextended borrowers, ignoring the
approximately half of U.S. homeowners who own their homes outright through
their own sweat, perspicacity, and prudence.
And there is still no focus on monitoring bank funding markets. The feared
outcome is nothing less than a 21st century bank run, this time from CDO
investors rather than depositors. High yields in RMBS in the past several years
led to a massive infusion of CDO hot money into the RMBS sector in an
environment similar to that of the thrift crisis of the late 1980s. Like the thrift
crisis and its aftermath, therefore, recent events not only threaten these
institutions, but also threaten the U.S. consumer and taxpayer as well. Indeed,
current estimates of losses due to the mortgage mess are on par with the thrift
crisis.
Perhaps of greater concern is the reputational risk posed to the U.S. capital
marketsmarkets that have historically been viewed as among the most
transparent, efficient, and well regulated in the world. The economic value of
mortgage securitization and the risk transfer value of CDO issuance support their
further use. However, there should be significant resources allocated to building
the regulatory framework surrounding their structuring, issuance, ratings, sales,
and valuation. We believe that efforts to provide transparency to these new
product areas can foster stability while maintaining liquidity to the underlying
collateral sectors and supporting further meaningful financial innovation and
capital deepening.
At present, however, even financial regulators are hampered by the opacity

of over-the-counter CDO and RMBS markets, where only qualified investors
may peruse the deal documents and performance reports. Currently none of the
bank regulatory agencies (OCC, Federal Reserve, or FDIC) are deemed
qualified investors. Even after that designation, however, those regulators must
receive permission from each issuer to view their deal performance data and
prospectus in order to monitor the sector. Nonetheless, we have shown that it is
not necessary to be a rocket scientist to understand many of the fundamental risks
of RMBS and CDOs.
Significant increases in public access to performance reports, CDO and
RMBS product standardization, and CDO and RMBS securities ownership
registration can help decrease the existing over-reliance on ratings agency inputs
to rate and ultimately value the securities and reducing the valuation errors
inherent in marked-to-model (rather than marked-to-market) portfolios. SEC
Regulation AB was a (late) start for ABS and RMBS. Overall, however, the U.S.
economy needs an efficient public CDO market that allows transparent open-
market pricing of market risk and outside research into new securities and
funding arrangements. U.S. homeowners and consumers deserve stable and
efficient funding to support their pursuit of the American dream.
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mason_rosner_v8 May 14, 2007

Where Did the Risk Go? How Misapplied

Many of the current difficulties in residential mortgage-backed securities (RMBS) and

Associate Professor of Finance and LeBow Research Fellow, Drexel University

7.Implications: When Mortgage Pools Perform Normally, Credit

The residential mortgage-backed securities (RMBS) market has experienced

I. UNRECOGNIZED RISK AND BOND RATINGS

go away. It can be diversified in portfolios, but diversification works to only

FIGURE 1: RESIDENTIAL RMBS YIELD SPREADS, MBA REFI INDEX, AND

Our previous report illustrated many of the key changes to residential

FIGURE 2: RISK GRADING IN THE MORTGAGE INDUSTRY

FIGURE 3: DEFAULTS ON ABS AND RMBS, 1994-2005

FIGURE 4: COLLATERAL LOSSES AND BOND DEFAULTS

Source: FitchIBCA, Residential Mortgage-backed Securities Criteria, Dec. 16, 1998.

FIGURE 5: U.S. HOME-PRICE APPRECIATION

Source: Nomura, Securitization & Real Estate Update, Mar. 1, 2007.

FIGURE 6: ABX:HE TRANCHE SPREADS FOR PRICING RMBS

A. A Brief Background on the Role of Credit Rating Agencies

3. Nomura, Structured Finance Trends Yield Spreads, Credit Support, and

modern portfolio management techniques, which require consistent quantitative

5. Nomura, Bond Rating Confusion, June 29, 2006, at 2 [hereinafter Rating

industry and has become an increasing proportion of their revenues.

FIGURE 7: GLOBAL STRUCTURED FINANCE ISSUANCE IS GROWING RAPIDLY

Source: Moodys Corporation, Investor Presentation (March 2007), available at

Source: Moodys Corporation, Investor Presentation (March 2007), available at

The concentration of rating agency power is not limited to the structured

in structured finance. For example, a recent report by the French securities

treatment of correlation, recoveries and time variation), it is likely to be a more important

B. Are Credit Rating Agencies Still Publishers or Are They Underwriters?

20. CESR Code 1.15, 2.5, 2.12, and 3.9.

27. Timothy J. Riddiough & Risharng Chiang, Commercial Mortgage-Backed

Because RMBS-based CDOs are generally comprised of lower- grade

39. See, e.g. FitchRatings Terms of Use,

agencies role is to assess the documentation and legal structure of a proposed

FIGURE 9: MOODYS STRUCTURED FINANCE RATING APPROACH

45. Authorite des Marches Financiers, supra note 31, at 9

C. New ConflictsThe Buy Side

While portfolio selection is generally considered to be efficient and driven by

As a result of this increasing complexity and opacity and the difficulties of

D. The Problems With Ratings In Structured FinanceEvolving Models

In a 2005 report from the Bank for International Settlements Committee on

classes.61 Uncertainty about the meaning of original ratings is significant62and the

With frequent adjustments to their structured finance models there seems to

the event of an unanticipated adverse event. Generally, when a rating agency

Primary a primary field for running their proprietary

78. Guidelines on External Credit, supra note 64, at 92 (Competent authorities

FIGURE 10: NEWLY REQUESTED DATA FIELDS

PRIMARY HIGHLY DESIRABLE DESIRABLE

Source: Moodys Revised US Mortgage Loan-by-Loan Data Fields, Apr. 3, 2007.

Moodys adds generally, in absence of key information, assumptions are

assessment of the capabilities of the originator, servicer or portfolio manager

96. Global Rating Criteria for Collateralised Debt Obligations, FITCHRATINGS,

While little publicly available information is available about the specific

appropriate and effective or if regulators would need to be more proscriptive.112 It

F. Rating Agencies Are Activist in Ways They Have Never Been

112. Committee of European Securities Regulators Report to the European

rating agencys largest single clients or as a result of fundamental analysis. It was

On October 1, 2002, the Georgia Legislature passed sweeping new anti-

G. Other Legal Risk Securitization Law

As we discussed previously in this paper, recent problems in the subprime

118. Georgia Fair Lending Act, GA Code. Ann. 7-6A-1 et seq.

III. TRADITIONAL BOND RATINGS DO NOT PROPERLY ACCOUNT FOR

While the type of discretionary decision-making described above can be